A few weeks ago I released on this site a “Stock Price Estimator.” The model is relatively simple in that it bases future stock price on a stock’s beta and projected index swings. A number of factors can cause the model to be misguided and downright wrong. As with any model, it’s important to understand its strengths and its weaknesses.
To learn about this models weaknesses (and conversely understand its strengths), I’d like to consider the social networking company QuePasa (QPSA). QPSA is a highly volatile tech stock that lives in the realm of new social media companies. It’s volatility creates an interesting situation, which makes for a good example in evaluating the limitations of the Stock Price Estimator model.
When evaluating the risk of a particular stock, one straight forward method is to look at the stock’s beta. A beta above 1 means more historic volatility in the stock than the overall market and less than one means a lower amount of volatility. When beta is quoted online, it is often done over a 5 year period and against the S&P 500. In the case of QPSA, it’s a small stock that does not fit the model of an S&P 500 type stock/company. Therefore, it’s important to know that you’re comparing against a somewhat similar index.
The index I selected to compare QPSA against was the Russell 2000. For one, QPSA recently joined the index and the index is built upon small companies that are growth oriented. The index contains companies that are much more akin to QPSA than the S&P500. (Actually, I should have compared it to one of the newly created social media indexes, but their historical track record is limited…that causes analysis problems.)
After compiling data for activity over a 5 year period for QPSA and the Russell 2000, I then calculated beta. It turned out that over a 5 year period, QPSA actually had a beta of .57. This means that it has almost 50% less volatile than the Russell 2000. This seemed odd to me since I have been watching QPSA for about a year now and know it can run up and fall back down fast. Therefore, I calculated beta based on a 1 year time frame. The beta now shown was 1.39. This is a significantly different picture.
What an investor must be aware of when referencing beta is the time frame which was used to calculate the figure, the index it is being compared against and whether or not the stock’s behavior over the time period considered has been relatively constant. In the case of QPSA some major changes in the company have caused investors to create much more activity within the stock. Therefore, its 5 year historic trend is no longer relevant. It must be understood in a shorter time period.
When using beta and market increase/decrease projections to estimate the future market price of a stock, it is vital that you understand the nature of the stock. Larger more stable companies are better suited to provide you with a more accurate predictive variable in terms of beta than small growth companies like QPSA.
The Stock Price Estimator is geared towards providing estimates on companies that are more set in their ways (highly correlated) with market movements than not. In the case of QPSA, it can cover a lot of ground in a positive or negative direction in a very short amount of time. A number of factors are causing this, which is beyond our discussion here. Yet, know that such activity make the beta less of a predictive variable because the index its based against even though similar in companies is not similar enough in price behavior.