Unlevered Beta Formula Ultimate Guide 2023

unlever beta

Based on the given information, the unlevered beta of Apple Inc. stood at 1.00. Essentially, the CAPM formula captures an investor’s expected rate of return relative to the level of risk taken. This ‘root-level’ view of a Company’s risk profile enables us to gauge the underlying risk of a Company, absent the impact of Debt. Unlevered Beta does not take into account the level of Financial Leverage (i.e., Debt) and risk profile of a company.

For example, a gold ETF will show a low β and R-squared in relation to a benchmark equity index, as gold is negatively correlated with equities. Negative β – A company with a negative β is negatively correlated to the returns of the market. For example, a gold company with a β of -0.2, which would have returned -2% when the market was up 10%. Low β – A company with a β that’s lower than 1 is less volatile than the whole market. As an example, consider an electric utility company with a β of 0.45, which would have returned only 45% of what the market returned in a given period. Depending on a given company’s capital structure we may find a large reduction or little to no reduction.

  • In technical terms, beta is the slope coefficient of a publicly traded stock’s returns that have been regressed against market returns (usually the S&P 500).
  • Despite being rare, a stock may have a negative beta, which means the stock moves opposite the general market trend.Unilever PLC shows a Beta of 0.46.This is significantly lower than 1.
  • How debt affects a company’s beta depends on which type of beta (a measure of risk) you mean.
  • The concept of re-levering beta was first proposed by Robert Hamada who is a Professor of Finance at the University of Chicago.

This allows the company to understand the cost of equity, showing how much interest the company is required to pay per dollar of finance. WACC is very useful in determining the feasibility of future capital expansion. These numbers in practice would be found through identifying a peer group for Biotech Oasis. Financial information from the peer group would then be averaged out in order to find the average levered beta and the average debt to equity ratio for the biotechnology industry. Systematic risk is the risk inherent in an individual stock due to the overall stock market’s risk. This type of risk may increase or decrease with changes in federal interest rates, economic expansions, and economic contractions.

Excel Example – Converting Equity to Asset Beta

In actuality the increase in beta exclusively represents the company’s increase in debt. While the levered betas were hardcoded assumptions, if done properly, the hardcoded values and the calculated values (converting unlevered beta back into levered beta) should match. From our formula, in which we de-levered beta (i.e. removed the effects of leverage), we are now left with the business-specific risk of each company, as intended. Based on the financial data we’ve collected so far, the pattern between levered beta and the debt/equity ratio should be clear. Here, we look at three companies with different assumptions for the levered beta and varying capital structures.

It is important to understand the concept of unlevered beta because it is predominantly used for a pure-play method which is an approach for determining the cost of equity. In this method, the equity beta of a publicly available comparable company is unlevered using the debt-to-equity ratio of a comparable company. Finally, the levered beta of the subject company is derived by re-leveraging the unlevered beta by using its debt-to-equity ratio. Let us take the example of John Doe who wants to calculate the unlevered beta of a company named GHK Ltd. It is a publicly listed company with a levered beta of 0.8, the total debt of $200 million and a market capitalization of $400 million. Help John Calculate the unlevered beta of the company if its effective tax rate is 30%.

unlever beta

Companies in certain industries tend to achieve a higher β than companies in other industries. A security’s β should only be used when its high R-squared value is higher than the benchmark. The R-squared value measures the percentage of variation in the share price of a security that can be explained by movements in the benchmark index.

Assume that Company Y operates in the same sector as Company Z and has a comparable risk profile and product line as this non-listed private company. The unlevered beta is either equal to or less than the levered beta, since it removes the debt component that adds to the risk. In effect, when a company takes on more debt, it translates to increased risk which is due to increasing leverage rather than market risk. Therefore, by removing the effect of debt, the unlevered beta helps in determining the risk of only the company’s assets. Levered beta, also known as equity beta or stock beta, is the volatility of returns for a stock, taking into account the impact of the company’s leverage from its capital structure.

Unlevered Beta Formula

If a company was to have a beta of two, then the risk of its stock would be twice as risky as the overall stock market. After executing this calculation we find that the fintech company’s unlevered beta is 1.26. Returning to our calculation of unlevered beta, all that remains is to plug our assumptions into the formula we discussed earlier.

  • Levered beta includes both business risk and the risk that comes from taking on debt.
  • His next assignment is valuation of Bolan Electric Arts (BEA), a company engaged in production of electric vehicles.
  • The unlevered beta is typically used in analysis alongside the levered beta to compare the risk of a stock to the market.
  • When it comes to unlevered beta, you can essentially assume that the company is financed entirely with equity with no debt financing – and all free cash flows (FCFs) belong to equity holder(s).
  • The company will now have to allocate a larger amount of its cash flow towards servicing higher debt payments.

This makes perfect sense since there is no capital structure impact on the returns. When you look up a company’s beta on Bloomberg, the default number you see is levered, reflecting the debt of that company. Since each company’s capital structure is different, an analyst will often want to look at how “risky” the company’s assets are, regardless of what percentage of debt or equity funding it has. To ‘unlever’ the beta, the levered beta for the company has to be known in addition to the company’s debt-equity ratio and corporate tax rate. ‘Unlevering’ the beta removes any beneficial or detrimental effects gained by adding debt to the firm’s capital structure. Here is my solution thus far, please let me know if I am on the right track.

Unlevered Beta

Josh Pupkin is a member of WSO Editorial Board which helps ensure the accuracy of content across top articles on Wall Street Oasis. On the other hand, unsystematic risk is the risk that is unique and specific to an individual company. This type of risk is separate from the overall market and can be difficult to quantify.

For a company with a negative β, it means that it moves in the opposite direction of the market. Theoretically this is possible, however, it is extremely rare to find a stock with a negative β. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts.

What are Equity Beta and Asset Beta?

You have to take out the financial leverage effect (unlever the
beta) to come up with a pure play or business beta. Let us take the example of Apple Inc. to illustrate the concept of unlevered beta for real-life companies. As per the available market information, the 1-year levered beta of the stock of the company is 1.08. As per the latest annual report, non-current term debt and current term debt at $93.74 billion and $8.78 billion respectively as on September 29, 2018. On the other hand, the current market capitalization stood at $922.64 billion. Calculate the unlevered beta of Apple Inc. if the effective tax rate for the year is 24.5%.

Investors can then accommodate for this phenomenon by extracting the potentially misleading debt impact. Since a company with debt is said to be leveraged, the term used to describe this extraction is called “unlevering.” Stock 1 has an equity beta of 1.21 and a net debt to equity ratio of 21%. After unlevering the stock, the beta drops down to 1.07, which makes sense because the debt was adding leverage to the stock returns. More precisely, it is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. In statistical terms, it is the slope of the coefficient for a security (stock) regressed against a benchmark market index (S&P 500).

How Does Debt Affect a Company’s Beta?

It is important to measure the riskiness of an individual company’s assets by removing any impact that debt has, and only evaluate how risky the equity of a company is. The equity beta is the volatility of a company’s stock compared to the broader market. A beta of 2 theoretically means a company’s stock is twice as volatile as the broader market. The number that shows up on most financial sites, such as Yahoo! or Google Finance, is the levered beta. By unlevering Company XYZ’s beta, we are able to see that the company’s risk profile relative to the overall stock market has not changed.

In most cases, when you see the use of beta or read about it in a textbook or journal, the standard beta is used. This version of beta can be thought of as “levered” because it includes the effect of the company’s use of debt, or leverage. The value of beta tells you the relationship between unlever beta the returns on an investment and the returns on the market. To determine the risk of a company without debt, we need to un-lever the beta (i.e., remove the debt impact). Individual firm regression betas
are noisy (have large standard error) and unlevering them only compounds
the noise.

unlever beta

Beta is the output of a Regression Analysis that compares an Individual Company’s returns to the return of the aggregate Stock Market (typically the S&P 500). But investors need to consider the bigger picture of the Company’s situation, including the level of Debt. Conversely, for a lower Equity Beta Company, we would expect lower returns. This Equity Risk Premium can be dialed up or down by the Beta, based on the level of risk inherent in the underlying Company. We want to calculate the Cost of Equity, so we start off with the Risk-Free Rate of Return with taking zero risk as the starting point. Below is an Excel β calculator that you can download and use to calculate β on your own.

Let’s Begin With Unlevered Beta (aka ‘Asset Beta’)

If a company has a relatively higher debt to equity ratio but the debt is AAA-rated it may be of less concern than a high debt to equity ratio with a junk debt issuance. All of the information necessary to unlever beta can be found in a company’s financial statements where tax rates and the debt/equity ratio can be calculated. In general, the unlevered beta will always be lower than the standard, levered beta if the company has debt. Extracting the debt from the equation through the use of the debt/equity ratio will always result in a lower risk beta. Compared to levered beta, the asset beta does not take into effect the impact of financial leverage (debt). Asset beta is commonly used in financial modeling and business valuation for professionals working in investment banking or equity research.

Before discussing the differences between levered vs unlevered beta, it’d be best to take a step back by defining the two types of risks. Beta (β) represents a company’s sensitivity to market volatility – otherwise referred to as systematic risk – compared to the broader market, which is used as the standard benchmark. Leverage is the amount of debt a company incurs to fund its assets and growth. For example, a company may borrow money to undertake a project, build a new manufacturing plant, or make an investment it hopes will increase its rate of return. The last segment in the formula is the debt-to-equity ratio, which shows how the standard beta is adjusted for the amount of debt the firm has.