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Which beta variant belongs in your calculation?
Beta is not one number. A value taken straight from a screen is a levered beta, and it carries the company's operating risk and its debt together — which is almost never the mix a valuation needs. The variant you choose changes the cost of equity without changing anything about the business.
What the beta factor measures, and how it is calculated, is covered separately. This article is about the variants: what each one contains and when it applies.
A myriad of beta variants exist, each distinguished by its calculation methodology and application. These distinctions are crucial for investors and analysts, as the variant selection significantly impacts the outcomes of risk analyses and valuation models.
Beta variants consider diverse factors, including a company's capital structure, sector, and prevailing market conditions. A nuanced understanding of these variants is indispensable for accurately assessing investment risks and making informed decisions.
Levered beta: Easily observable on the equity markets
Levered beta, often termed “asset beta” quantifies the comprehensive risk of a company's equity. It encompasses both the operational risk inherent in its business and the financial risk stemming from its debt structure.
Determining the levered beta of a publicly traded company is relatively straightforward due to the daily price discovery on stock markets, which provides ample historical price data. This data can be utilized to calculate levered beta.
To calculate this, the historical price performance of a company's stock is compared to that of an appropriate market index.
Levered beta is calculated through statistical analysis, typically using linear regression, to determine the correlation between a company's stock returns and those of a market index. The slope coefficient of this regression represents the levered beta.
Several crucial decisions must be made when calculating levered beta:
- Period: The analysis typically spans 1 to 5 years, though a longer timeframe can mitigate the impact of short-term market volatility.
- Return period: Returns can be calculated daily, weekly, or monthly. Monthly returns are commonly used, striking a balance between data availability and the need to account for short-term market fluctuations.
- Selection of the stock index: Selecting the appropriate market index is paramount. For German companies, the DAX is often a suitable choice, while the S&P 500 is commonly used for US firms.
- Currency: Calculations can be performed in the local currency, US dollars, or euros. The choice of currency depends on the desired level of comparability and the availability of data.
Raw beta factor vs. adjusted beta factor: correction or not?
Both raw beta and adjusted beta are derived from the previously calculated levered beta. However, they diverge in their assessment of the historical beta's reliability for future projections.
Raw beta is the beta value derived directly from historical data. It reflects a stock's past price movements relative to the market. The underlying assumption of raw beta is that this historical relationship will persist into the future.
A common critique of raw beta is its tendency to revert to the market's mean trend (a beta of 1) over time, a phenomenon known as mean reversion. If unadjusted, raw beta can lead to overestimated future risk for stocks with historically high betas (greater than 1) and underestimated risk for those with historically low betas (less than 1).
Adjusted beta is an effort to rectify the shortcomings of raw beta. This involves modifying the historical beta value using a specific factor to account for mean reversion.
A well-known method for adjusting beta is the Blume adjustment. This involves weighting the historical beta value with a factor between 0 and 1 and normalizing the remainder to 1 (the market beta).
Unlevered beta factor: pure business risk
Unlevered beta exclusively focuses on a company's operational business risk. It quantifies how its stock price fluctuates relative to the overall market, solely attributable to its business activities, independent of its capital structure and financing risk.
Since unlevered beta is not directly observable, it must be derived from levered beta. This involves adjusting levered beta for the impact of debt. The specific calculation depends on several factors:
- Tax effects: Interest payments on debt are tax-deductible in many countries, reducing the effective cost of debt. This tax shield, which varies across jurisdictions, can lower a company's overall cost of capital.
- Debt capital risk: The risk of debt capital, often referred to as “debt beta”, is frequently estimated using the risk-free interest rate or the interest rate on a short-term government bond.
When calculating unlevered beta, the valuer's judgment plays a more significant role compared to levered beta, as it requires subjective assessments. The choice of models and assumptions can lead to varying results.
Relevered beta factor: business risk and financing risk
Relevered beta is essentially the inverse of unlevered beta. While unlevered beta removes financing risk from the overall risk, relevered beta adds it back in.
This allows for a more straightforward comparison of companies with diverse capital structures. Relevered beta is frequently employed in mergers and acquisitions to assess the implications of the takeover on the capital structure of the resulting merged entity.
Debt beta: Debt capital can also contain risks
Thus far, we have primarily focused on equity beta. However, debt capital is not risk-free. Debt beta quantifies the sensitivity of debt capital returns to fluctuations in the overall market.
While debt capital is often perceived as more stable and less risky than equity, its value and expected return can fluctuate. These fluctuations, aside from indirect insolvency costs, are primarily driven by the company's business risk.
Since this risk is independent of the financing mix, incorporating debt beta provides a more accurate representation of a company's overall risk by considering both equity and debt risk.
By explicitly including debt beta, the pure business risk (unlevered beta) can be more accurately isolated, separating it from financing risk.
Most common use case: company valuation
Determining the cost of capital is a central component of any company valuation, especially for privately held companies.
All the discussed beta variants can be applied here:
- Levered Beta: Since direct market data is unavailable for privately held companies, the levered beta is typically derived from a peer group of comparable publicly traded firms. The valuer can choose between raw beta, which is the unweighted average of the peer group's betas, or an adjustment like the Blume adjustment. The latter accounts for the generally lower volatility of smaller companies compared to large market indices.
- Unlevered Beta: To isolate the financing risk, the levered beta of each individual company in the peer group is converted into an unlevered beta. This reflects the pure business risk, independent of the level of debt.
- Relevered Beta: Relevered beta incorporates the specific financing structure of the target company. After deriving the unlevered beta from the peer group, it's adjusted to the valuation object's leverage ratio through a process known as “relevering”.
- Debt Beta: For companies with substantial debt, both within the peer group and the valuation object, debt beta should be considered. It measures the sensitivity of debt yields to market fluctuations and can enhance the accuracy of cost of capital determination.
Beta factor: Variants and application
A comprehensive understanding of beta variants and their effective application is essential for making informed decisions in the financial realm. As a metric quantifying an investment's systematic risk relative to the broader market, beta plays a pivotal role in company valuation and the calculation of capital costs.
The selection of the appropriate beta factor significantly impacts the accuracy of forecasts and valuations. While levered beta reflects a company's overall risk, unlevered beta isolates its business risk. Debt beta, on the other hand, quantifies the risk associated with borrowed capital.
By analyzing beta values, company valuators can more accurately assess an investment's risk profile. A high beta suggests greater volatility and, consequently, higher risk, while a low beta indicates lower volatility and reduced risk.
Beta factors are also instrumental in determining the cost of capital, which represents the minimum return investors expect for their invested funds. Generally, a higher beta translates to higher capital costs, as a higher return is required to compensate for increased risk.
