Every second, someone in the world invests in Equity, Bonds, and other Hybrid securities in spite of knowing the fact that there are systematic risks (risks that can’t be eliminated through diversification) involve in these securities. Now the question is why would an investor devote his money to these securities knowing of the risk present in them? Do they have some financial tools to measure these risks? Or is there any other factor that motivates these investors to invest in risky securities? The answer to these questions is YES. Every investor is aware of the financial tool to measure the systematic risk, i.e., BETA and there is one factor that motivates these investors to switch from risk-less to risky securities i.e. Upside Risk (when returns are more than expected), that’s why we have multi-billionaires like Warren Buffet, Rakesh Jhunjhunwala, etc. because they believe in upside risk, however, they never underestimate downside risk because of the volatility in the market and biasness involved in the valuation. Let’s discuss in detail BETA and what is levered and unlevered Beta?
Beta represents the relative volatility of a given investment/stock with respect to the market and statistically, we can measure the risk added by an asset to the market portfolio by its covariance with that portfolio. Assets that are riskier than average will have a beta greater than 1 and assets that are safer than average will have a beta less than 1. The risk-less asset will have a beta of 0.
Now, Suppose you are valuing ABC Ltd. using Discounted Cash Flow analysis and that company’s beta is not available in any database, so, it would be appropriate to take comparable companies’ beta and use the average/median of those beta as a proxy to calculate the risk of the subject company, however, do you really think that using comparable companies’ beta would solve our problem? The answer would be NO because every company has a different capital structure and hence the risk also differs. For example, We cannot use the beta of tech giants like Amazon or Google for our subject company, which has $200-$300M revenue and only $5M +EBITDA. Therefore, we adjust the beta as per the subject company’s capital structure to calculate the value of the company. This adjustment is nothing but “Levered and Unlevered Beta”. Let’s get into the detail of this:-
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Levered and Unlevered Beta
Levered beta (or geared Beta) takes debt and equity in its capital structure and then compares the risk of a firm to the volatility of the market. Also, it gives tax benefit to the company by adding debt to its capital structure, however, the more debt a company has, the more earnings are used to pay back that debt and this, in turn, increases the risk associated with the stock. So, due to different capital structures and levels of debt, it would desirable to take unlevered beta for effective comparison with the market.
Calculation of levered beta: – BL= BU (1 + (1-t) (D/E))
Here: BL- Beta Levered, BU = Beta Unlevered, t- Corporate Tax, D- Market value of Debt (usually the book value of debt), and E- Market value of Equity (Market Cap).
Unlevered beta (or ungeared beta) takes only equity in its capital structure and then compares the risk of a firm to the risk of the market. Unlevered beta is useful when comparing companies with different capital structures as it focuses on the equity risk and is also referred to as the “Asset Beta” since its value is determined by the assets (or businesses) owned by the firm, however, unlevering the beta removes beneficial effects gained by adding debt to the firm’s capital structure. Generally, the Unlevered beta is lower than the levered beta however, it could be higher in some cases especially when the net debt is negative (meaning that the company has more cash than debt).
To Unilever the beta, we should know the levered beta, which we can get from databases and online sources like Yahoo!, along with the company’s debt-equity ratio and corporate tax rate.
Calculation of Unlevered Beta: – BU = BL / [1 + ((1 – Tax Rate) x Debt/Equity)]
Let’s learn the process of adjustment in Beta:-
First step: – We have taken 4 companies i.e. A Ltd., B Ltd., C Ltd., and D ltd. (let’s assume these are comparable companies of the subject company i.e. F Ltd.).
Second step: – We have taken equity beta or raw beta, Equity Market value, Debt market value, and tax information from a particular database.
Third step: – Calculate Debt/Equity ratio i.e. Debt market value/ Equity Market value.
Fourth step:-. The formula used to adjust beta is (0.67) x raw beta or equity beta + (0.33) x 1, which defines that, 67% of weightage is given to the company’s equity beta (Raw Beta) and 37% weightage is given to 1, which is market average because adjusted beta takes an assumption that a security’s true beta will move towards the market average, of 1, over time.
Fifth step: – Calculate asset beta or unlever beta by using the formula:-
BU = Adjusted Beta / [1 + ((1 – Tax Rate) x Debt/Equity)].
If you’re interested in Levered and unlevered beta, check out our CAPM article.
Conclusion: – Levered and unlevered beta both are crucial, however, it is very important to understand the subject company’s capital structure, how they will make money, and then need to do the appropriate adjustments to come up with the beta associated with the subject company.