Levered beta is the beta that contains the effect of capital structure.
Unlevered beta is the beta after removing the effects of capital structure.
Beta as we know is the measure of variability of a company’s stock price in relation to the overall stock market. However, in case of private companies the beta does not exist. Private companies or unlisted companies do not have historical prices for its shares.
In order to calculate the appropriate beta of a company or for an unlisted company the easiest way is to take the mean or median beta of the company and unlever the beta. Though this is widely accepted and not incorrect, however, the better practice should be to select only a set of 10 – 12 comparable companies on the basis of size, risk, profitability and other comparable criteria’s and take their mean or median beta. When we take the mean or median beta of a company the result is somewhat smoothed.
Selecting the right set of comparable companies is the first step in calculating the appropriate beta; the debt in the capital structure makes a company more risky and increases the risk of bankruptcy. Secondly, the capital structure i.e. the debt equity ratio of our subject company may not be same as that of our comparable companies. Therefore, we must remove the effect of debt from the comps beta for each of our comps (unlever the beta).
The company specific risk of our subject company that arises due to debt in the capital structure should now be taken into account by re-levering the unlevered beta of the comparables using the debt equity ratio of our subject company.
The above exercise may seem to be time consuming but as it is said that it’s the analyst job to select the correct data, the model by itself will not correct the data. Stay tuned for more update on valuation concepts.