Abstract
The capital asset pricing model (CAPM) suggests that an investor's cost of equity capital is determined by beta, a measure of systematic risk based on how returns co-move with the overall market. We propose to replace beta with downside beta, a measure more consistent with investors' perception of risk. Recent empirical evidence suggests that downside beta better captures the risk-return relationship in both emerging markets and developed markets. Grouping companies into industries by two-digit Standard Industrial Classification (SIC) code, we show that the average downside beta can be very different from traditional beta. We discuss the implications of using downside beta on valuation and provide a simple example to illustrate the application in valuation for both diversified and undiversified investors.
