Estimation of Beta

Module 7
 Estimation of Beta

Beta

In the CAPM, the beta of the asset has to be estimated relative to the market portfolio.

In the APM and multifactor model, the betas of the asset relative to each factor have to be
measured.

There are three approaches to estimate these parameters:

• To use historical data on market prices for individual assets

• To estimate the betas from fundamentals and
• To use accounting data.
 Estimation of Beta

Historical Market Beta

This is the conventional approach for estimating betas used by most services and analysts.

For firms that have been publicly traded for a length of time, they compute returns on its
equity in weekly or monthly intervals over that period.

These returns can then be related to returns on a proxy for the market portfolio to get a beta
in the capital asset pricing model, or to multiple macroeconomic factors to get betas in the
multifactor models or APM.

The standard procedure for estimating the CAPM beta is to regress stock returns (𝑅𝑗 ) against
market returns (𝑅𝑚 ):

𝑅𝑗 = 𝑎 + 𝑏 𝑅𝑚

Where, 𝑎 = Intercept from the regression

𝐶𝑜𝑣𝑎𝑟𝑖𝑎𝑛𝑐𝑒 (𝑅𝑗, 𝑅𝑚 )
𝑏 = Slope of the regression =
𝜎2𝑚
 Estimation of Beta

Historical Market Beta

σ 𝑅𝑖− 𝑅ത 𝑖 (𝑅𝑚− 𝑅ത𝑚 ) σ 𝑅𝑚− 𝑅ത𝑚 2

𝐶𝑜𝑣 (𝑅𝑖 , 𝑅𝑚 ) = , 𝜎2
𝑚=
𝑛−1 𝑛−1

The slope of the regression corresponds to the beta of the stock and measures the riskiness
of the stock. This slope, like any statistical estimate, comes with a standard error, which
reveals just how noisy the estimate is.

There are three decisions the analyst must make in setting up the regression.

• Length of the estimation period

• Uses of return interval

• Choice of a market index

Estimation of Beta
 Estimation of Beta

Fundamental Betas

The beta for a firm may be estimated from a regression but is determined by fundamental
decisions that the firm has made on what business to be in, how much operating leverage
to use in the business, and the degree to which the firm uses financial leverage.

The beta of a firm is determined by three variables: 1)the type of business or businesses
the firm is in, 2) the degree of operating leverage in the firm and 3) the firm’s financial
leverage.

Types of Business: Since betas measure the risk of a firm relative to the market, the more
sensitive a business is to overall economic conditions, the higher is its beta.

Degree of operating leverage: A firm that has high operating leverage i.e. high fixed costs
relative to total cost, will also have higher variability in operating income than would a
firm producing a similar product with low operating leverage. This higher variance in
operating income will lead to a higher beta for the firm with higher operating leverages.
 Estimation of Beta

Fundamental Betas

Degree of Financial Leverage: Higher leverage increases the variance in earnings per share
and makes equity investment in the firm riskier. If all the firm’s market risk is borne by the
stockholders (i.e. the beta of debt is zero), and debt creates a tax benefit to the firm, then

𝛽𝐿= 𝐵𝑢 [1+(1-t)D/E]

Where, 𝛽𝐿 = levered beta for equity in the firm

𝐵𝑢 = Unlevered beta of the firm (i.e. the beta of the firm without any debt)
t= Marginal tax rate for the firm
D/E= debt-to-equity ratio

As leverage increases as measured by the types debt-to-equity (D/E) ratio – equity

investors bear increasing amounts of market risk in the firm, leading to higher betas.

The unlevered beta of a firm is determined by the types of the businesses in which it
operates and its operating leverage. This unlevered beta is often also referred to as the
asset beta since its value is determined by the assets owned by the firm.
 Estimation of Beta

Fundamental Betas

Degree of Financial Leverage:

Thus, the equity beta of a company is determined by both the riskiness of the business it
operates in and the amount of financial leverage risk it has taken.

Since the financial leverage multiplies the underlying business risk, it stands to reason
that have high business risk should be reluctant to take on financial leverage.

It also stands to reason that firms which operate in relatively stable businesses should be
much more willing to take on financial leverage.
 Estimation of Beta

Bottom-Up Betas
 Estimation of Beta

Bottom-Up Betas

Solution to the Regression Beta Problem

 Estimation of Beta

Bottom-Up Betas: Determinants of Beta

 Estimation of Beta

Bottom-Up Betas: Steps of estimating Levered Beta

 Estimation of Beta

Bottom-Up Betas: Adjusting for Operating Leverage

 Estimation of Beta

Bottom-Up Betas: Adjusting for Financial Leverage

 Estimation of Beta

Bottom-Up Betas: Steps of Bottom-up Beta

 Estimation of Beta

Bottom-Up Betas: Steps of Bottom-up Beta

Adjustment for cash

Investment in cash and marketable securities have betas close to zero. Consequently, the
unlevered beta that we obtain for a business be looking at comparable firms may be
affected by the cash holdings of these firms. To obtain an unlevered beta cleansed of cash:

𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎
Unlevered beta corrected for cash = 𝑐𝑎𝑠ℎ
(1−𝐹𝑖𝑟𝑚 𝑣𝑎𝑙𝑢𝑒)
 Estimation of Beta

Why Bottom-up Betas?

1) We can estimate betas for firms that have no price history since all we need is an
identification of the businesses in which they operate. In other words, we can obtain
bottom-up betas for initial public offerings, private businesses and divisions of
companies.
2) Since the beta for the business is obtained be averaging across a large number of
regression betas, it will be more precise than any individual firm’s regression beta
estimate. The standard error of the average beta estimate will be a function of the
number of comparable firms, can be approximated:

𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝜎𝐵𝑒𝑡𝑎
𝜎𝐴𝑣𝑒𝑟𝑎𝑔𝑒 𝑏𝑒𝑡𝑎 =
𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝐹𝑖𝑟𝑚𝑠

Thus the standard error of the average of the betas of 100 firms, each of which has a
standard error of 0.25, will be only 0.025:

0.25
Standard error of beta = = .025
100
 Estimation of Beta

Why Bottom-up Betas?

3) The bottom-up beta can reflect recent and even forthcoming changes to a firm’s
business mix and financial leverage, since we can change the mix of businesses and the
weight on each business in making the estimate. We can also adjust debt ratios over time
to reflect expected changes in financing policy.
 Estimation of Beta

Illustration: Bottom-up Beta for Disney

Disney is an entertainment firm with diverse holdings. In addition to its theme parks, it has
significant investments in broadcasting and movies. To estimate Disney’s beta in 2004, we
broke the business into four major components:

1. Studio entertainment
2. Media Network
3. Park resort
4. Consumer Products

For the above four businesses, unlevered beta is estimated by looking at comparable firms
in each business. The following table summarizes the comparable used and the unlevered
beta for each of the businesses.
 Estimation of Beta

Illustration: Bottom-up Beta for Disney

 Estimation of Beta

Illustration: Bottom-up Beta for Disney

To obtain the beta for Disney, we have to estimate each business’s weight in relation to
Disney as a company. The value for each of the divisions was estimated by applying the
typical revenue multiple at which comparable firms trade to the revenue reported by Disney
for that segment in 2003. We first estimated the enterprise value for each firm by adding
the market value of equity to the book value of debt and subtracting out cash. We divide
the aggregate enterprise value by revenues for all of the comparable firms to obtain the
multiples.
The unlevered beta for Disney as a company is a value-weighted average of the
betas of each of the different business areas. The following table summarizes this
calculation:
 Estimation of Beta

Illustration: Bottom-up Beta for Disney

 Estimation of Beta

Illustration: Bottom-up Beta for Disney

The equity beta can then be calculated using the financial leverage for Disney as a firm.
Combining a marginal tax rate of 37. 3%, the market value of equity of $55,101 million and
an estimated market value of debt of $14,668 million, we arrive at the beta for Disney in
early 2004:

14,668
Equity beta for Disney = 1.0674 [ 1+ (1- .373) ( 55,101)] = 1.2456

This contrast with the beta of 1.01 that we obtained from the regression, and is a much true
reflection of the risk in Disney.
 Estimation of Beta

Accounting Beta

Changes in earnings at a division or a firm, on a quarterly or an annual basis can be

regressed against changes in earnings for the market, in the same period, to arrive at
an estimate of a market beta to use in the CAPM.

Pitfalls of this approach:

• Accounting earnings tend to be smoothed out relative to the underlying value of the
company, resulting in betas that are biased down, especially for risky firms or biased
up for safer firms.
• Accounting earnings can be influenced by non-operating factors, such as changes in
depreciation or inventory methods, and by allocations of corporate expenses at the
divisional level.
• Accounting earnings are measured once every quarter and often once every year,
resulting in regressions with very few observations and not much power.
 Estimation of Beta

Estimating the Cost of Equity

Having estimated the risk-free rate, the risk-premium and the beta, we can now
estimate the expected return from investing in equity at any firm. In the CAPM, this
expected return can ne written as:

Expected return = Risk-free rate + Beta * Expected risk premium

In the APM and multifactor model, the expected return would be written as follows:

𝑗=𝑛
Expected return = Risk-free rate + σ𝑗−1 𝛽𝑗 ∗ 𝑅𝑖𝑠𝑘 𝑝𝑟𝑒𝑚𝑖𝑢𝑚𝑗
 Estimation of Beta

Few Consideration while estimating the Cost of Equity

• Small Firms: Once the expected return is obtained from a risk and return model, some
analysts try to adjust it for the model’s empirical limitations. For instance, studies of the
CAPM indicate that it tends to understate the expected return for small firms. As a
consequence it is a common practice to add what is called a small firm premium to
obtain the cost of equity for small firms. This small premium is usually estimated from
historical data to be the difference between the average annual returns on small
market cap stocks and the rest of the market, about 3 to 3.5 percent.

• Privately and closely held business: The owner of a private firm, generally has the bulk
of his or her wealth invested in the business. Consequently, he or she cares about the
total risk in the business rather than just the market risk.
1. In these cases, it is reasonable to add a premium to the cost of equity to
reflect the higher risk created by the owner’s inability to diversify.
2. It is also possible that adjust the beta to reflect total risk rather than market
risk. This adjusment is a relatively simple one since the R-squared of the regression
measures the proportion of the risk that is market risk. Dividing the market beta by the
square root of the R-squared yields a total beta.
 Estimation of Beta
Few Consideration while estimating the Cost of Equity

For a private firm with a bottom-up market beta of 0.82 and an average bottom-up R-
squared of about 16 percent, the total beta can be computed as follows:

𝑀𝑎𝑟𝑘𝑒𝑡 𝑏𝑒𝑡𝑎 0.82

Total Beta = = = 2.05
𝑅−𝑠𝑞𝑢𝑎𝑟𝑒𝑑 .16

Cost of Equity = 4% + 2.05(4.84%) = 13.92%

• Companies with Country risk Exposure: Three ways to incorporate the country risk
premium in the cost of equity

1. Equity Exposure Approach: Cost of Equity = Risk free rate + country risk premium +
Beta * mature market equity risk premium

2. Beta Scaled Approach: Cost of equity = risk-free rate + beta * (Mature market equity risk
premium + country risk premium)

3. Lambda Approach: If we define a company’s exposure to country risk to be 𝜆, cost of

equity will be :
Cost of equity = Risk-free rate + Beta * mature market risk premium + 𝜆 *country risk
premium