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Beta as an Indicator
A company’s beta is a measure of the volatility, or systematic risk, of a security, as it
compares to the broader market. The beta of a company measures how the
company’s equity market value changes with changes in the overall market. It is used in
the capital asset pricing model (CAPM) to estimate the return of an asset.
Beta, specifically, is the slope coefficient obtained through regression analysis of the
stock return against the market return. The following regression equation is employed to
estimate the beta of the company:
Due to the lack of market data on the stock prices of private companies, it is not possible
to estimate stock beta. Therefore, other methods are required to estimate their beta.
Assume we want to estimate the beta of an illustrative energy services company with a
target debt-to-equity ratio of 0.5, and the following companies are the most comparable
companies:
Comparable Companies, as of year-end 2014 Beta Debt Equity D/E
Halliburton Company (
1.6 7,840 16,267 0.48
HAL)
Schlumberger Limited. (
1.65 10,565 37,850 0.28
SLB)
Helix Energy Solutions Group Inc. (
1.71 523.23 1653.47 0.32
HLX)
Superior Energy Services, Inc. (
1.69 1,627.84 4079.74 0.40
SPN)
Averages
Weighted average beta 1.64
Weighted average D/E 0.34
The equity-weighted average beta of the four companies is 1.64. This is close to the
arithmetic average of about 1.66. The chosen method to find the average beta may
depend on the specifics of the data and size range of the comparable companies.
For instance, if there are one very large company and three very small companies, then
a weighted average method will be biased toward the beta of the large company. In this
particular example, however, we can take the weighted average beta as it is close to the
arithmetic average, which gives equal weight to each company’s equity.
The next step is un levering the average beta. For this, we need the average debt-to-equity
ratio for these companies. The weighted average debt-to-equity ratio is 0.34.
Where D/E is the average debt-to-equity ratio of the comparable companies, T is the tax
rate, Bu the unlevered beta, and BL the levered beta.
In the final step, we need to re-lever the equity using the target debt-to-equity ratio of the
private company, which equals 0.5.
In this example, the beta of the illustrative private company is higher than the average
levered beta due to a higher target debt-to-equity ratio.
This method has certain pitfalls, including the fact that it neglects the difference between
the size of the private company and that of the public company. Most of the time, publicly-
traded companies are much larger in size compared to private ones.