Ten Questions about Bottom-up Betas What is a bottom-up beta?

A bottom-up beta is estimated by starting with the businesses that a firm is in, estimating the fundamental risk or beta of each of these businesses and taking a weighted average of these risks. What are the steps involved in estimating bottom-up betas? There are four steps: Step 1: Break your company down into the businesses that it operates in. A firm like GE operates in 26 businesses but Walmart is a single business company. Do not define your business too narrowly or you will run into trouble in step 2. Step 2: Estimate the risk (beta) of being in each business. This beta is called an asset beta or an unlevered beta. Step 3: Take a weighted average of the unlevered betas of the businesses you are in, weighted by how much value you get from each business. Step 4: Adjust the beta for your company�s financial leverage (Debt to equity ratio) What should we use as comparable firms? While the narrow version of comparable firm defines it to be another firm in the same business that your firm is in, the broader definition of comparable firm includes any firm whose fortunes are tied to your firm�s success and failure (or vice versa). From a practical standpoint, try the following. Define �comparable firm� narrowly as a firm that is very similar to your firm. (Thus, if your firm makes entertainment software, look for other firms that are entertainment software firms as well.) If you get a large enough sample (see answer to question 4), stop. If not, try expanding your sample, using any or all of the following tactics: i. Define comparable more broadly (all software as opposed to entertainment software). ii. Look for global listings of companies in the same business; all entertainment companies listed globally would be an example. iii. Look up and down the supply chain for other companies that feed into your company and that your company feeds into. Thus, you may start looking for software retailers that get the bulk of their revenues from entertainment software. How big a sample of firms do we need? Think of this question in the following way. Any sample size greater than one is an improvement on a regression beta. However, the more firms that you have in your sample, the greater the potential savings in error. With a sample of 4, your standard error will be cut by half; with a sample of 9, by two-thirds; with a sample of 16, by 75%.... Try to get to double digits for your sample size, if you can. If you cannot, settle for 6-8 firms and you are still saving a substantial amount in terms of estimation error. There is clearly a trade-off between how tightly you define �comparable firm� and your sample size. If you define comparable narrowly (firms like just like yours in terms of size and what they do), you will get a smaller sample. If you can get to double digits with a narrow definition, stay with it. If your sample size is too small, try one of the techniques suggested in the answer to question 3 to expand your sample.

how do we estimate the unlevered (asset) betas? Simply put.) Why do I need to adjust for cash and how do I do it? The regression beta for a company reflects all of its assets (including cash). you can break the unlevered beta down into a business component (reflecting the elasticity of demand for your company) and an operating leverage component: . In practical terms. If you do have that information. Individual firm regression betas are noisy (have large standard error) and unlevering them only compounds the noise. Averaging first should reduce the noise. Since we want a pure software business beta. Otherwise.! However. its regression beta will be lower because cash is riskless. You have to take out the financial leverage effect (unlever the beta) to come up with a pure play or business beta. hoping that the law of large numbers bails you out. with betas estimated against local indices. Thus. yes. you will be attaching the beta of the largest firm or firms in your group to all of the firms in the sample. Once we have the regression betas for the firms. this adjustment is trivial: Cash-adjusted beta = Unlevered beta / (1 – Cash/ Firm Value) Firm value = Market value of Equity + Market value of Debt Is it possible to adjust these unlevered betas for operating leverage? It is possible.Once we have comparable firms. Regression betas are levered betas but they reflect the financial leverage of the companies in the sample (and not your company). Unlevered beta = Regression beta / (1 + (1-tax rate) D/E) Should we unlever each firm�s beta and then average or average and then unlever? I prefer to average first and then unlever. but only if you know what costs are fixed and what are variable not only for your firm but for all of the firms in your sample. should we use simple or weighted averages? Use simple averages. you can afford to get sloppy with these details. If we assume that cash has a beta of zero. we should be cleaning up the betas for cash holdings. (There are always strange outliers with D/E ratios that make simple averages go haywire. What tax rate and debt to equity ratio should I use for the sector? To be safe. you average their regression betas and clean up those betas for financial leverage and cash holdings. if a firm is 60% software and 40% cash. as your sample size increases. Thus. Microsoft�s beta will become every software company�s beta. go with a marginal tax rate and use either the median D/E ratio or the aggregate D/E ratio for the sector. leading to better beta estimates. if you have 100 global firms in your sample. Why do we need to correct for financial leverage? Your company can have a very different policy on how much debt to use than the typical firm in the sample. here are some issues that you wil face: Do the regression betas for the comparable firms all have to be over the same time period and against the same index? In a perfect world. you can get away using an average of these 100 betas since some are likely to be over estimated and some under estimated.

If a firm has changed its business mix. The savings will approximate 1/ Square root of number of firms in the sample. Why is a bottom-up beta better than a regression beta? Bottom up betas are better than a regression beta for three reasons They are more precise. Since you are interested in the value of the business (and not the value of equity). Can bottom-up betas change over time for a company? Yes. even if your firm is only one business and has not changed its debt to equity ratio over time. The other is that the debt to equity ratio for the firm can change over time.tax rate) (Debt/Equity)) You can use the current debt to equity ratio for the firm you are analyzing or even a target debt to equity (if you feel that change is on the horizon) in making this computation. One is that the mix of businesses can change over time./E)) – Beta of debt (1-t)(D/E) The tricky part is estimating the beta of debt. use an EV/ Sales multiple. and for two reasons. A regression beta reflects past debt to equity choices. estimate a beta for debt and compute the levered beta as follows Levered Beta = Unlevered Beta (1 + (1-t)(D. leading to a different unlevered beta.Business Risk beta = Unlevered beta/ (1 +Fixed Costs/ Variable Costs) The problem from a practical standpoint is getting the fixed and variable cost breakdown. THE CPA IN INDUSTRY . An alternative is to apply a multiple of revenues (earnings) to the revenues (earnings) from each business to arrive at an estimated value. How do we adjust for financial leverage? The standard adjustment for financial leverage is to assume that debt has no market risk (a beta of zero) and to use what is called the Hamada adjustment: Levered Beta = Unlevered beta (1 + (1. However. You can use weight based on revenues or earnings from each business but you are assuming that a dollar in revenues (earnings) has the same value in every business. leading to changes in the levered beta. you will be better off using bottom up betas. The standard error in a bottom-up beta estimate is more precise because you are averaging across regression betas. If you feel uncomfortable about the assumption that debt has no market risk. If a firm has changed its debt to equity ratio. How do we weight these unlevered betas to arrive at the beta for the company? The weights should be market value weights of the individual businesses that the firm operates in. This multiple can be estimated for the comparable firms (from which you estimated the betas). the bottom up beta can be easily adjusted to reflect those changes. you can reflect that more easily in a bottom-up beta because you set the weights on the different businesses. If you use revenues. you should look at EV multiples (and not equity multiples). Thus. these businesses do not trade (GE Capital does not have its own listing) and you have to estimate the market values. A regression beta reflects past business mix choices.

nondiscretionary). Why Use Bottom-Up Betas? Computing the cost of capital for a growth company. The use of a bottom-up beta in computing the cost of equity component of the cost of capital is an exceptional method of capturing all types of risk. EVA is useful to the managers of the company as well as to external financial analysts. can be problematic. Financial risk is determined by a company’s level of debt. increasing the proportion of debt may allow a company to lower its cost of capital and accept more investments. have very high beta measurements. Furthermore. Risk-adjusted discount rates should incorporate business and operating risk as well as financial risk. In light of this. a business’ current value of operations is calculated as the present value of the expected future free cash flows discounted at the cost of capital. The cost of capital is also used in the computation of economic value added (EVA). rapidly changing capital structures.May 2003 Estimating Cost of Capital Using Bottom-up Betas By Nancy L. Financial theorists agree that using a correct risk-adjusted discount rate is needed to analyze a company’s potential investments and evaluate overall or divisional performance. Inc. It is a measure of the economic value created by a company in a single year. and increasing size are inherent qualities of growth firms. For example. Borrowing money will only exaggerate the impact of the risk. however. EVA is computed by subtracting a capital charge (operating invested capital multiplied by weighted average cost of capital) from after-tax operating income. and have discretionary products such as technology. The abundance of information available on the Internet makes computing a risk-adjusted hurdle rate simple.. Investment theory specifies that firms should invest in assets only if they expect them to earn more than their risk-adjusted hurdle rates. Yet the literature to date has provided little to explain the computation of a riskadjusted cost of capital using readily available information. Business risk is measured by the nature of the products and services the business provides (discretionary vs. a hospital business. Operating risk is determined by the cost structure of the firm (higher fixed assets relative to sales increases operating risk). Changing product mixes. industries that exhibit high operating leverage and short life cycles. illustrates the procedures. CPA. The application presented would . the length of the product’s life cycle (shorter life cycles create more risk). PhD. there is a need to deal more explicitly with risk when establishing hurdle rates for growth companies. and the size of the company (economies of scale can reduce risk). using the constant dividend growth model to compute the cost of equity yields a cost of equity equal to the company’s growth rate. In value-based management. Beneda. Knowing the cost of capital also permits a company to determine its value of operations and evaluate the effects of alternative strategies. changing cost structures. University of North Dakota Every business must assess where to invest its funds and regularly reevaluate the quality and risk of its existing investments. This analysis is useful as a guide in decision making as well as for projecting future financing needs. because growing companies typically do not pay dividends. For example. Knowing a business’ cost of capital allows a comparison of different ways of financing its operations. An example using Community Health Systems.

the more sensitive a business is to market conditions. Financial statements can be obtained from Hoovers or Compustat. The August 12. . and is usually defined in terms of the relationship between fixed costs and total costs. created by regression betas. by eliminating the need for historical stock prices to estimate the firm’s beta. and Hoovers. the standard error. an unlevered beta is computed (Exhibit 1. the debt-to-equity ratio. Developing a Bottom-Up Beta Exhibit 1 illustrates the computation of a bottom-up beta for Community Health Systems. and the tax rate. A bottom-up beta is estimated from the betas of firms in a specified business. bottom-up betas are designed to be a better measure of the market risk associated with the industry or sector of the business. the reported beta (reported betas are levered) and recent financial statements for each comparable company should be obtained. Other things being equal. Panel A of Exhibit 1 shows a set of eight comparable companies identified by Hoovers. and managers of growth firms. Panel A). 2002. The first step in estimating a bottom-up beta is to identify the business and a set of comparable established companies. Inc. the marginal tax rate and the debt-to-equity ratio is determined. Second. equity research analysts. the more financial risk or operating risk a firm has. Second. The degree of operating leverage is a function of a company’s cost structure. First. 2000. rather than from the average leverage over the period of the regression. A company that has high operating leverage (high fixed costs relative to total costs) will also have higher variability in earnings before interest and taxes than a company producing a similar product with low operating leverage. all report companies by industry and sector.com. Third. thereby addressing problems associated with computing the cost of capital. Value Line and Compustat provide reported betas. the higher its beta. the problem of a changing product mix is eliminated because the business computes a different cost of capital for each product line. based on both value and growth indicators.be especially useful to investors who hold growth stocks in their portfolios. the higher its beta. Intuitively. Overall. From the financial statements. The unlevered beta for each comparable company is determined using the following: Equation 1: Bl = Bu x [1 + (1 – tax rate) x (D / E)]. venture capitalists. the higher variance in operating income will lead to a higher beta for companies with high operating leverage. CHS has an average three-year historical sales growth rate of 25. or Bu = Bl / [1 + (1 – tax rate) x (D / E)] The unlevered beta (Bu) in Equation 1 is the beta of a firm with no debt and is determined by the types of businesses in which it operates and its operating leverage (risk). the levered beta is computed from the company’s current financial leverage. and does not have a reported beta. Bottom-up betas also capture the operating and financial risk of a company. Because betas measure the risk of a firm relative to a market index. (CHS).6%. The computation of an unlevered beta removes the effects of financial leverage of the comparable firms. Fortune reported it to be one of the top 40 companies traded. Compustat. It went public on June 9. is reduced. Value Line. Using the reported beta.

the type of businesses in which it operates. Exhibit 1. operating income should change more than proportionately when sales change. measuring the operating leverage of a company is difficult because fixed and variable costs are often aggregated in income statements. and from this. using Equation 1. with higher leverage increasing income during good times and decreasing income during economic downturns. Thus the computed levered beta for CHS is a good estimate of the company’s market risk with regard to operating leverage and growth. the weighted average unlevered beta for the comparable companies is 0. The third step is to compute a weighted-average unlevered beta of the comparable companies. compute the levered beta (BL) for the company being evaluated.917. As shown in Panel B of Exhibit 1. While operating leverage affects betas.6 appear to be fairly consistent with the operating leverage and growth rates of the comparable companies. The obligated payments on debt increase the variance in net income. project. Operating leverage can be computed using the following formula: Equation 2: Operating leverage = (% change in operating income) / (% change in sales) If the company’s project or division being analyzed has a higher (lower) operating leverage than the comparable firms. an increase in financial leverage will increase the beta. it appears that these .1 and three-year historical growth rate of 25. obtained from CHS’s financial statements.917. The computation of the unlevered beta of the comparable company is weighted according to company size measured as the market value (MV) of equity plus debt. For companies with high operating leverage. the unlevered beta should be adjusted upward (downward). The levered beta (BL) of a firm is a function of its operating leverage. Panel C.The debt to equity ratio (D/E) in Equation 1 represents the amount of financial leverage or the debt level of the company. the more favorable the debt financing. Because the largest companies have the highest operating leverage. The higher the tax rate. operating leverage and growth should also be observed for comparable companies. The operating leverage of the entity being analyzed should be compared to the operating leverage of the comparable companies. CHS’s operating leverage of 1. Other things being equal. The debt-to-MV ratio of 0. The unlevered betas appear to be associated with a combination of size and operating leverage. is slightly higher than the debt-to-MV ratios for comparable companies and factored into the computation of CHS’s levered beta of 0.72. This procedure adjusts the beta for the financial risk and tax benefits associated with the individual firm. or division in question. The levered beta computed for CHS is 0. Finally.42. and its financial leverage. The tax advantage of debt financing is represented in the formula by (1 – tax rate). provides a detailed explanation of the computations and sources of data for the information in Panels A and B. The debt-to-equity ratio and tax rate of the company under consideration is used to lever up the unlevered beta in Equation 1. The levered beta (BL) for CHS is then computed using the weighted-average unlevered beta of the comparable companies. It is possible to get an approximate measure of the operating leverage of a company by looking at changes in operating income as a function of changes in sales.

The low betas of companies in the hospital industry indicate a low market risk. in comparison to a riskless investment. the market risk premium. a market risk premium of 12.com)—as a riskless rate in all types of analyses will yield a close approximation of the true value.3% (finance. however. Capital Asset Pricing Model (CAPM) and the Cost of Equity Exhibit 2 shows the computation of the cost of equity for CHS using the capital asset pricing model (CAPM). however. using a long-term government rate—which can be obtained from Bondsonline (www. The annual growth rates for the most recent three years of the comparable companies range from 2.5% to 42. The five-year annual projected growth rate for 2002 through 2007 of the hospital industry is reported by Yahoo Finance to be 16.7%. and the bottom-up beta of 0. Once these costs have been incurred. do not appear to correlate with growth rates. the cost of equity for CHS is estimated to be 16. there is no default risk and no uncertainty about reinvestment rates. the maturity of the security should be matched with the length of the evaluation. Equation 3. The average historical market risk premium over the period 1926 to 1999 for small companies is 12. The most common approach to estimating the market risk premium is to estimate the historical premium earned by risky investments (stocks) over riskless investments (government bonds). Cost of Debt The cost of debt measures the current cost of borrowing funds to finance projects. product. To eliminate uncertainty about reinvestment rates. higher growth leads to higher fixed costs and higher betas. For growth companies in high-risk industries.1%. or division.companies attempt to balance business risk with operating risk by increasing their operating leverage. The unlevered betas. such as technology. In practice. Consequently. This can be explained by the industry’s nondiscretionary products and longer product life cycles. Growth companies generally tend to have significant fixed costs associated with setting up infrastructure and developing new products. and the tax advantage associated with debt. Equation 3: Cost of equity = (riskless rate + beta) x market risk premium A riskless asset is one in which the investor knows the expected return with certainty. and the beta of the firm. 2002). even for growth companies.5%.1%. as of September 4. as reported by Ibbotson’s. the default risk of the company.com.917. and the bottom-up beta computed in Exhibit 1.6%. The components that go into measuring the cost of equity using the CPM include the riskless rate. The cost of debt is measured by the current level of interest rates.yahoo. Exhibit 2 illustrates the computation of the cost of equity for CHS.bondsonline. the variable costs are relatively low. Equation 4: Pre-tax cost of debt = Treasury bond rate + default spread of company’s debt . It should be a function of how risk-averse the investors are and how risky they perceive stocks and other risky investments to be. The market risk premium measures the extra return that would be demanded by investors for shifting their money from a riskless investment to an average-risk investment. Using a risk-free rate of 5.

Exhibit 3 illustrates the computation of the cost of debt for CHS. and equity is more likely to have a higher market value than book value. from Equation 4. Exhibit 4 illustrates the computation of the cost of capital for CHS. Equation 5: Cost of Capital = ke [E / (D+E)] + kd [D / (D+E)] The market value of equity (E) for CHS is $2. Generally the book value of debt is an adequate proxy for the market value unless interest rates have changed drastically. Cost of Capital The estimated cost of capital should be based on the market values of a company’s debt and equity. These companies have more equity in their capital structures. and the number of shares outstanding is reported on the financial statements.354 million. and the associated ratings for the comparable companies indicate a bond rating of B+ for CHS.The default spread is the difference between the long-term Treasury bond rate and the company’s bond yield. . as 14%. calculated as the number of shares outstanding times the stock price as of December 31. The stock price can easily be obtained from Yahoo Finance. using the book value cost of capital will tend to understate the cost for most companies. especially highly levered companies.standardandpoors. The interest coverage ratio for CHS is 2. Default spreads can be found at Bondsonline if the company has a bond rating. Bond ratings can be found at www. The default spread for this rating from Bondsonline is 8.com. From a practical standpoint. the rating may be obtained by computing the company’s interest coverage ratio and adjusting for industry standards or expected future interest coverage. 2001. which can be obtained from either Hoovers or Compustat. since a company has to earn more than its market value cost of capital to generate value.5%. which is 14. For companies that are not rated (CHS is not rated by Standard & Poor’s).40%.

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