What Is Beta in Valuation? Meaning, Types, Formula & Example

2. Role Of Beta In Cost of Equity Valuation

Beta is utilized directly in determining Cost of Equity in the CAPM (Capital Asset Pricing Model) Valuation methodology. This is an input into DCF (Discounted Cash Flow) methods of calculating the value of a business, thus making it an essential driver of the total value of a business.

CAPM Formula:

Cost of Equity = Rf + Beta (Rm - Rf)

Where: Rf = Risk Free Rate

Rm -Rf = Risk Premium

Beta=Beta Value

The greater the value of Beta, the greater the Cost of Equity and therefore, the lower the value of the business because of a higher expected required return on equity for the added associated risk.

Analysts heavily rely on beta for the following reasons:

• - Beta illustrates how much market risk a company is subject to.
• - The beta of a company impacts the company's discount rate, which ultimately affects the way I value companies.
• - Analysts can use beta to compare risk between different public companies.
• - Beta can also be used to assess the level of financial risk associated with a company's use of debt or leverage.

In general, beta provides a numerical representation of what level of risk a company has and allows for better estimates of returns on investments and value.

3. There are three types of betas used when valuating a company

A. Historical beta is typically the most used method for calculating beta because it uses data from historical stock prices and compares them to past movements of the relevant stock market index (through regression analysis). However, there are some limitations of using historical betas. First, historical betas assume that companies will experience the same level of risk in the future as they did in the past or return back to their original levels of risk, assuming they remain in similar economic environments. Second, historical betas assume that the company's capital structure will remain constant in the future, which is not always the case.

B. Adjusted beta is used to correct for the tendency of historical betas to drift towards a value of 1 over time, which is unrealistic for many companies. To address this problem, analysts apply the Blume adjustment to historical beta to arrive at an adjusted beta. The Blume Adjustment is calculated as follows:

Adjusted Beta = (0.67 x Historical Beta) + (0.33 x 1)

This adjustment helps to maintain the adjusted beta value consistent with the expected market movement and/or behaviour of the company's stock.

C. Levered Beta (Equity)

The Levered Beta demonstrates the total risk for the shareholders, "Equity" incorporates business risk along with the financial risks associated with the use of debt.

βlevered=βunlevered×(1+(1-T)ED)

As such, higher (more) leverage has a direct effect on the increase in Levered Beta which demonstrates greater risk for the Equity Shareholders.

D. Unlevered Asset Beta

Unlevered Beta accounts only for business risk and therefore removes the influence of financial/ capital structure.

βunlevered = (1+(1-T)ED)×βlevered

Analysts will often use Unlevered Beta to determine the level of operating risk for companies within a certain industry.

4. How Beta is Used in Valuation: The Step by Step Process

Most times, when attempting to assign a beta number to the value of a company (more specifically to determine the value of a private company or a new company) you may not be able to obtain this information readily, hence analysts will typically use industry comparable data to make their estimates.

A. Identify Peer Companies

Select companies that are comparable to the company being valued with similar business models, operating environments, etc. Eg. similar size, revenues, gross margins.

B. Collect Leveraged Beta's

This is usually readily available via the internet from various MDA (Market Data Aggregator) Providers or Financial Web sites.

C. Convert Leveraged Betas to Unleveraged Beta

By converting the Leveraged to Unleveraged Beta we eliminate the effect of capital structure on the Beta number.

D. Calculate the Average Unleveraged Beta

Calculating the average Unleveraged Beta provides the analyst with the normal level of business risk for the industry.

E. Re-Leverage the Beta

The average Unleveraged Beta calculated for the group of Industry Comparables, must be re-levered to represent the risk profile (D/E) of the Company being valued.

F. Input the Re-Leveraged Beta into the CAPM Formula.

This means that the Cost of Equity has a direct effect on:

• - Discounted Cash Flow valuation
• - Weighted Average Cost of Capital
• - Project Appraisal
• - Investor Decision Making

5. Example: Beta and Cost of Equity

Assuming:

Risk-free interest rate = 7%

Market risk premium = 6%

Beta = 1.3

The calculation for Cost of Equity becomes:

Re = 7% + 1.3 * 6% = 14.8%

Now, if the beta increases to 1.6, the calculation for Cost of Equity becomes:

Re = 7% + 1.6 * 6% = 16.6%

Thus, as the beta increases, prospective investors will demand a higher return, which in turn causes the value of the firm to decrease. This serves to illustrate how even small changes in beta can dramatically affect discounted cash flow values.

6. The Factors that Influence A Firm's Beta

A. Industry Characteristics - Cyclical industries like those in the automobile and real estate sectors experience periodic fluctuations in business activity, which results in a higher level of beta (risk).

B. Operational Leverage - Firms with greater levels of fixed costs will experience a greater variance in their profit margins compared to firms that have a lower fixed cost structure; this results in an increased beta.

C. Financial Leverage - Firms with a higher level of debt create greater variability in their returns, which increases the overall risk to shareholders.

D. The Firm's Size and Stability - Smaller firms generally have higher betas due to their cash flow being less predictable when compared to larger firms.

E. Market Conditions - Bull and bear markets can distort beta values because of significant changes in investor behavior during extreme market cycles.

7. Limitations of Beta

Despite the fundamental importance of Beta in finance, there are limitations:

• Because it is derived from past information, it may not provide relevant future risk measurements.

• It fails to consider risks that are independent of the market (i.e., firm specific).

• When a company undergoes major strategic changes, it may not measure the risk accurately.

• Due to differences in the length of time and/or frequency a Beta is measured, different Betas result. Nevertheless, Beta is the most established and comprehensible means for estimating systematic risk.

Conclusion

Beta represents an important and foundational concept in valuation models, as it relates to the investor's determination of the firm's risk of equity through measuring how sensitive the firm is to actions in the stock market. In conjunction with risk assessment, Beta quantifies uncertainty into a risk value. Thus, while understanding the limitations of Beta is necessary, it provides an excellent reference point when comparing relative levels of risk across different businesses and industries, especially for students, investors and financial professionals, with regard to making accurate valuations and investment decisions.