Why Do we Unlever and Relever Beta?

By adjusting the unlevered beta of Company X for its leverage, we will find the beta of Company X to be 1.17. The capital asset pricing model can be used for publicly listed companies. Finding beta of projects or companies that are not publicly listed is not possible through CAPM due to the lack of data. Unlevered and levered beta is used in this method to estimate the beta. When evaluating a business, it is important to assess underlying performance with as well as without the impact of leverage.

The measure is used to summarize the effects this type of leverage has on a firm’s cost of capital—over and above the cost of capital as if the firm had no debt. Thus, the contribution of a company’s equity to its risk is measured by unlevered beta. Levered beta is a measure of the risk of a stock or business based on their tax rate, total debt, and total equity. 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.

While the levered betas were hardcoded assumptions, if done properly, the hardcoded values and the calculated values should match. In the first part of our tutorial, we’ll calculate the unlevered beta starting from levered beta. As a result, the market will require higher potential returns and more compensation for assuming systematic risk .

Calculating Levered Beta (Technical Stock Market Analysis)

Find Company X’s Unlevered Beta by Adjusting Company A’s unlevered beta for the capital structure of Company X. In case of a buyout, the target’s firm current capital structure doesn’t really matter to the acquiring firm. So, the acquiring firm first unlevers and then relevers beta to determine the impact of multiple debt levels. Such calculations allow the acquiring firm to get the optimal or desired capital structure. Comparable Firms Average BetaAverage D/E RatioPersonal Hygiene0.920%Medical1.260%Note that the average betas above denote the average of the levered or equity betas of these firms.

This way, only the sensitivity of a firm’s assets to the market will be factored in. When calculating levered beta, the formula consists of multiplying the unlevered beta by 1 plus the product of (1 – tax rate) and the company’s debt/equity ratio. A company’s levered beta is reported on financial databases such as Bloomberg and Yahoo Finance.

Therefore, although companies don’t often use debt beta , yet it can be seen that it is a really important metric, especially in the case of highly leveraged companies. Supply chain disruptions and inflation pose additional systematic risks in the market. In a particularly recent example, the COVID-19 pandemic and subsequent lockdowns disrupted world economies and the global supply chain, leading to the current levels of inflation in the global market. Likewise, say a stock in the semiconductor sector with groundbreaking technology has a beta greater than 1. This means that if the market moves upward by 10%, this stock could move 20%.

When you look up a company’s beta on Bloomberg, the default number you see is levered, and it reflects the debt of that company. Since each company’s capital structure is different, an analyst will often want to look at how “risky” the assets of a company are regardless of the percentage of its debt or equity funding. Beta is a measure of the volatility, or systematic risk, of a security or portfolio in comparison to the market as a whole.

Beta indicates whether an investment is more volatile or less volatile. Beta, which has a value of 1, indicates that it exactly moves following the market value. In this case, Company XYZ is considered less risky than the market NASDAQ with its beta of 0.817. Let’s take an example to better understand the beta equation calculation in a better manner. Then, prepare the beta coefficient excel sheet, as shown below.

Lastly, beta is typically based on the historical average financial leverage (i.e. capital structure) over the regression period, rather than the current debt-to-equity mix. Another concern is that the capital structure (debt/equity ratio) of companies, levered beta formula which is a key determinant of volatility , changes over time as companies mature and new developments in industries emerge. Often referred to as the “equity beta”, levered beta is the beta of a firm inclusive of the effects of the capital structure.

Constant leverage assumption: the Harris–Pringle formula

So by comparing unlevered beta with the unlevered beta of other companies, investors can get a clear idea of the equity risk they are assuming. Ltd. and use its annual report figures to calculate levered beta. According to available market information, the 1-year unlevered beta of the company stock is 1.89. Ltd if the current market capitalization is $259.81 billion, while the applicable corporate tax rate in South Korea is 25%. Let us take the example of Apple Inc. to demonstrate how levered beta is computed for real-life companies. According to information available at one of the stock market database, the 1-year unlevered beta of the company’s stock is 1.08.

It is used to measure an investment’s risk when looking at whether a market is more stable or volatile and does not take into account a company’s debt and liabilities. Therefore, it’s used to measure more systematic risks in the market. It is different from the asset beta of the firm as the same changes with the company’s capital structure, which includes the debt portion.

• The use of beta as a proxy for risk has received widespread criticism from many practitioners, who believe it to be a flawed measure of risk.
• Discount rates are a key input to investment appraisals, asset valuations, profitability assessments and the setting of regulated revenue allowances.
• Debt-equity RatioThe debt to equity ratio is a representation of the company’s capital structure that determines the proportion of external liabilities to the shareholders’ equity.
• According to available market information, the 1-year unlevered beta of the company stock is 1.89.

For example, imagine based on the capital structure, demand, and debt-to-equity ratio of a certain stock tied to natural gas fracking that a company has a levered beta of less than 1. This would typically mean that regardless of a movement in the overall market, this stock would be relatively stable. If the market were to fall 10%, then this stock would perhaps only fall 2% because its stability supersedes that of the market overall. The beta formula is a way of measuring a company’s risk profile. When analysts produce an investment report that analyzes the risk profile of a company, they will typically have a beta formula. They will use either an unlevered beta or levered beta formula.

Levered beta and unlevered beta differ in their inclusion of a company’s debt-to-equity ratio when calculating the beta. Levered beta addresses the unique risks for a company based on its capital structure and operations, whereas unlevered beta addresses more systematic market risks. Hamada’s equation relates the beta of a levered firm to that of its unlevered (i.e., a firm which has no debt) counterpart. It has proved useful in several areas of finance, including capital structuring, portfolio management and risk management, to name just a few. This formula is commonly taught in MBA Corporate Finance and Valuation classes. It is used to determine the cost of capital of a levered firm based on the cost of capital of comparable firms.

Unlevering and relevering beta is very similar to de-assembling and then re-assembling of capital structure. Both processes allow the company to study the relative impact of each part of the capital structure. Also, it helps in understanding the cost of equity and the WACC . From a valuation perspective in a buyout opportunity there is quite often a dramatic change in capital structure, specially within Leveraged and Management Buy outs .

Step 1. Levered Beta and Capital Structure Assumptions

However, there are divergences in terms of how tax shields should be discounted depending on the financing strategy of a firm. The largest limitation of equity beta is it only relies on past returns. This means only past market performance is included in the beta. As a result, it is impossible to forecast future impacts on returns.

Underlying AssetUnderlying assets are the actual financial assets on which the financial derivatives rely. Thus, any change in the value of a derivative reflects the price fluctuation of its underlying asset. Such assets comprise stocks, commodities, market indices, bonds, currencies and interest rates. An out of the money option may have a distinctly non-linear payoff.

Examples of systematic risk

The cost of equity is typically estimated using the CAPM, described in the box below. But, some of Delta’s largest competitors, JetBlue Airways and United Airlines, both have a beta of 1.39. This makes Delta a much more attractive investment once it is compared to competitors. This is not a great mark and says Delta Air Lines is more volatile than the market.

Levered Beta vs Unlevered Beta

This is where unlevered beta comes in handy, as it allows you to compare company betas by excluding the impact of each company’s debt structures. Levered beta is often used by financial analysts to calculate the cost of equity of a stock through the Capital Asset Pricing Model . This is important because you’ll want to include the impacts of debt when trying to find the equity value of a company. To do this, look up the beta for a group of comparable companies within the same industry, un-lever each one, take the median of the set, and then re-lever it based on your company’s capital structure. According to the CAPM, the equilibrium required rate of return on equity equals the ‘risk-free’ rate of return, plus a premium to reflect the relevant risk.