Beta

What is Beta?

Beta - the simple concept and formula with a fancy name that I couldn’t grasp quickly when recruiting due to said fancy name. Simply put, Beta is a measure of how risky a company is compared to the broader market.

This is a quick breakdown of the way Beta is quantified and what that means qualitatively.

Beta’s Role in the CAPM Formula

Here is the CAPM formula that is used to calculate the Cost of Equity (CoE).

Now we see that Beta is multiplying the Market Risk Premium (MRP) formula to right-size the formula for the company you’re analyzing. As a reminder, the MRP is a measure of the excess returns required to compensate for investing in the broader stock market compared to a risk-free security. And, Beta, is a quantification of how risky a company is compared to the broader market.

Did that just click for you?

We know that a Beta > 1 means it is more risky than the market, a Beta < 1 is less risky and when Beta = 1, it is as risky. So if a company’s Beta is > 1, this part of the CAPM formula would suggest that this company should have a higher required return to compensate for risk when compared to the broader market.

Example

Let’s say the MRP is 8%.

If a company has a beta of 1.5: The return would be 12% (1.5 × 8%). Indicating it needs a higher return to compensate for a higher risk.

If a company has a beta of 0.5: The return would be 4% (0.5 × 8%). Indicating it only needs a lower return to compensate for a lower risk.

If a company has a beta of 1: The return would be 8% (1.0 × 8%). Indicating it only needs the same return as the market due to being equally risky.

How to Calculate Beta

Technically, Beta = Covariance of the Stock’s Returns & Market Returns / Variance of Market Returns.

If you’re dying to try it out, go for it. But, it’s not necessary at all. The “common” way to find beta is with the below:

If you’re valuing private companies

You can easily find comparable companies’ Betas online and pick the median if your business is private. Use the same selection methodology you would use in a comparable companies analysis.

If you’re valuing public companies

You can find their beta online. Typically, bankers use S&P CapIQ or Bloomberg.

The fun part about this is un-levering and re-levering beta, which you may have to do for a public company but always have to do with private companies.

How to Calculate Levered & Un-Levered Beta

Alright un-lever, re-lever what the heck is this guy talking about? We’re going to look at this through the lens of private companies for an example. But before that let’s get into why we do it.

When you look up a Beta of a company online, it’s naturally levered as it takes into account the capital structure of the company. Capital structure means the % of debt & equity that a company uses to finance themselves. D / D + E and E / D + E.

But, the capital structure of the company we’re analyzing is going to be different than its comparable companies, meaning it won’t tell us much unless we remove the capital structure. Since we’re analyzing a company with a different capital structure than the comparables, we must create a set of Betas that are reflective of how risky a company is, regardless of what percentage of debt or equity it has.

Think about it as using levered Betas as an example is like trying to measure the average height of students in a classroom but they’re all wearing different types of shoes with varying midsoles. Unlevering beta is takin’ the shoes off.

Un-Levered Beta Formula

Let’s mock this up in an Excel example for a company with a publicly listed Beta of 1.3, $300 in Total Debt and $500 in Total Equity:

So if we were finding Beta for a private company using comps, this is the example Step 1 calculation we would have to run on every company.

Time for Step 2; we need to re-lever Beta using the capital structure of the company we’re analyzing. Let’s look at the formula we need for that:

Let’s use this to find the levered Beta of the company we just un-levered, but instead of using their capital structure, we will use the capital structure of the company we are valuing:

As we can see, our Beta changed pretty drastically once we re-levered it. Hey, what’s up with that?

The key here is the D / E. Notice how the comparable company has 66% more equity than debt and our target company has the same amount of equity and debt. Remember, Beta is a measure of volatility and risk. So with the re-levered being higher than the original Beta (remember, this is also levered), it’s essentially saying that our target company is riskier than the comparable company.

The answer why is simple. Since debt holders get paid out before equity holders, the more debt you have as a % of total capitalization, the riskier it is to be an equity holder. So, with our target company having 50% of their capital structure comprised of debt, it is riskier than our comparable company that only has 38% of their capital structure comprised of debt.

The key points for technicals here are the formulas and the qualitative information. You will not have to pull an entire median set and find beta while doing summer analyst recruiting.