Calculating Beta
Beta provides many valuable insights to a company’s volatility and risk profile that investors, creditors, and potential partners will be evaluating when considering financing, investing in, or partnering with your business.
Interested in calculating your company’s beta but not sure where to start or what it means? Meet with us today to see how we can help you!
What is Beta (β)?
Beta, in the context of finance and investing, refers to a measurement of the volatility, or systematic risk, of a security or a portfolio compared to the market as a whole. Understanding beta is crucial for small business owners and entrepreneurs because it not only influences investment decisions but also provides insights into the risk profile of their business or industry.
A beta of 1 suggests that the security's price will move with the market. A beta less than 1 indicates that the security is less volatile than the market, while a beta greater than 1 indicates higher volatility compared to the market. For instance, if a stock has a beta of 1.2, it is presumed to be 20% more volatile than the market. In other words, if the market increases 1.0%, a stock with a beta of 1.2 would increase 1.2%.
Key Discussion Points
Beta quantifies a security's volatility relative to the market, essential for small business owners to assess investment, business risks, and understand their company’s risk profile for potential investors and business partners.
A beta of 1 implies a business is just as risky as an investment in the broader market, less than 1 indicates lower volatility or less risk, and greater than 1 suggests higher volatility or more risk, impacting investment decisions and business risk profiles.
Beta is crucial for calculating a company's cost of equity, a significant component of the overall cost of capital, influencing financing and investment choices.
Calculating the beta for your specific company involves finding industry-specific public company betas, and adjusting for capital structure (un-levering and re-levering) to derive a beta that reflects the unique financial structure of your small business.
Calculating levered beta for small businesses involves challenges like data availability, changing capital structures, and the need for industry-specific adjustments, requiring regular updates and professional insight for accuracy.
Below we’ll walk you through the process of calculating a beta for your specific company that you can confidently use in cost of equity calculations.
Getting very technical for a moment, beta measures the covariance of your company’s returns with the stock market’s returns (how they move together) and divides that covariance by the variance of the stock market’s returns (how the stock market moves) over the same period. Luckily there’s a simpler way to approach calculating your beta that doesn’t require the vast historical data or the statistical analysis.
The approach we are going to take is to find public company betas, un-lever them, meaning we remove the impact of their capital structure from the beta calculation, and the re-lever them with your company’s capital structure. Don’t worry, this may sound daunting but it really just requires some simple math and a short bit of research.
The steps we are going to follow to calculate your company beta are:
Find the weighted average beta, and debt-to-equity ratios for publicly traded companies in the same industry as you. Since these betas incorporate the capital structure, they’re considered levered.
Calculate the weighted average unlevered beta for the publicly traded companies, removing the capital structure impact.
Calculate the levered beta using your company’s specific capital structure.
For the purposes of this calculation, let’s assume the following information:
Your company operates in the construction industry, specifically residential home building.
Your company’s capital structure currently consists of $300,000 of debt and $850,000 of equity.
The corporate tax rate is 30%.
Calculating Private Company Beta (β)
Step 1 - Find Public Company Beta (β) and Debt-to-Equity Ratios
Our first step is to find public company betas and debt-to-equity ratios so we have an industry level benchmark that we can manipulate to calculate beta for our example company. Going online to either Google Finance or Yahoo Finance, we can find the data for other single-family home construction companies.
Using Yahoo Finance as an example, we can look up Lennar Corporation, a publicly traded residential home builder and easily find their beta (highlighted in image on left, below). Then, click on the “Statistics” tab in the header options (in the middle) and scroll down the page to the balance sheet section for total debt and debt/equity ratio. You can then divide the debt by the debt/equity ratio to get the total equity. In doing this we get the following data for Lennar:
Beta of 1.56
Total debt of $5.14 billion
Total equity of $26.72 billion (total debt divided by debt/equity ratio)
Debt/Equity ratio of 19.24%
We then repeat the process for other publicly traded residential home builders and get the following table:
To calculate the average beta, you can take one of two approaches.
The first approach is to take the weighted average beta based on the equity of the sample companies. This approach would be taken when the companies are relatively similar in terms of total equity in the companies. In our example above, the equity weighted average beta would be 1.58. The problem with this approach here is the equity values for these companies vary significantly. By taking the equity weighted average we’re skewing our data towards the larger companies. Again, this approach is better when all sample companies have similar equity values.
The second approach is to simply take average the beta figure across the sample companies, which is what we did here. This approach eliminates the impact that companies with significantly larger equity values would have on the equity weighted average calculation. With this logic, we arrive at an average beta of 1.55, implying these an investment in these companies is 55% more volatile than the broader stock market.
To calculate the average debt-to-equity ratio, we simply sum the total debt and the total debt for each company and then divide the debt into the equity. In this example all of our companies have a total of $15.65 billion in debt and $66.11 billion in equity which equates to a debt-to-equity ratio of 23.67%.
Step 2 - Calculate Unlevered Beta (β) for Public Companies
With the average public company beta and debt-to-equity ratio in hand, it’s time to calculate the unlevered beta for these companies.
Remember, unlevered beta is a calculation that eliminates the impact of the capital structure for these companies on the levered beta calculation. It removes the impact of debt, reducing the beta calculation to only the systemic risk of investing in that particular industry of the stock market based on the sample company data. We do this so we can later re-lever the beta by applying your company’s capital structure, giving you a custom beta for your small business that can be used in cost of equity calculations.
To calculate the unlevered beta, we’ll use the following formula:
By plugging in our average beta (1.55), average debt-to-equity ratio (23.67%) and our assumed corporate tax rate (30%) from above we can do the following calculation:
With an unlevered beta of 1.32, we can see that an investment in residential construction companies is 32% more volatile than the broader market before we account for the additional risks of leverage (debt financing) that individual companies have in their capital structure.
Step 3 - Calculate the Levered Beta (β) for Your Company
With our unlevered beta in hand, we can now apply the capital structure of our example business to understand the increased risk due to the amount of debt financing. To do that we’ll use the following formula, which is just the inverse of the unlevered beta formula:
As we stated earlier, our example company has total debt of $300,000 and total equity of $850,000 which means the debt-to-equity ratio is 35.29% and we’ll continue to assume a tax rate of 30%. By bringing in the unlevered beta of 1.32 from above, we can make the following calculation:
We’ve now determined that our example residential home building company has a levered beta of 1.65 which is 0.33 greater than the unlevered beta of 1.32. This means that the capital structure for our company is expected to add 25% more volatility than the industry average unlevered beta.
With this figure, we now have a comprehensive view of the equity risk faced by investors in our example company. By recalculating the levered beta with various levels of debt (different debt-to-equity ratios), we can see how debt levels alter the company's risk profile. This can help guide strategic decisions on capital structure to optimize shareholder value. It’s important to calculate this figure on at least an annual basis as your company undergoes changes and continues to grow since the levered beta will change with your business and you don’t want the business to become too volatile or risky for investors.
Benefits of Calculating Beta (β)
For small business owners and entrepreneurs, calculating levered beta offers several benefits by providing valuable insights for decision making and strategic planning by helping owners and investors understand the impact the amount of debt will have on your company’s risk profile.
Competitive Analysis: Levered beta offers insights into how the company's risk level compares to competitors, especially those with similar capital structures, aiding in strategic positioning and providing a path to potential competitive advantage.
Cost of Capital: Levered beta is key component in calculating the cost of equity, which is a component of the company’s weighted average cost of capital (WACC). A lower WACC can increase the company's valuation and having the beta available will give more credibility to the cost of equity calculations you provide.
Debt Financing Terms: Knowledge of how debt impacts the company's risk can assist in negotiating terms with lenders, potentially leading to better financing conditions. Better financing terms will also lead to a lower weighted average cost of capital as the cost of debt is a key component of that figure.
Equity Valuation: Potential equity investors will perform their own beta and cost of equity calculations. Having these estimates internally provides a basis for negotiating a more favorable valuation with potential investors by quantifying the risk-return profile of the company's equity.
Expansion and Diversification: Understanding the risk associated with the company's equity can help in making strategic decisions about expanding or diversifying the business operations.
Market Sensitivity: Knowing your company’s levered beta helps in understanding how sensitive the business is to market fluctuations, taking into account the company's debt level. This is important for contingency planning and stress testing market downturns, recessions, depressions and other macro or micro-economic scenarios.
Optimal Capital Structure: It aids in assessing the impact of current and potential debt levels on the company's risk profile, guiding decisions on the optimal mix of debt and equity financing.
Professionalism: Demonstrating an understanding of financial metrics like levered beta can enhance credibility with stakeholders, including creditors, potential equity investors, and companies that may be looking at acquiring or merging with your company.
Risk Management: By knowing the level of systematic risk, owners can perform scenario analysis that helps them make informed decisions about risk management strategies and insurance coverage.
Knowing the levered beta for your business and understanding what it means for your company’s risk profile are important pieces of information to have as your business grows and you look for additional forms of financing. Along with other data, beta can help guide business owners and entrepreneurs in managing risks, making informed investment decisions, and strategically planning for the future. Understanding and effectively utilizing beta can lead to more resilient and adaptive business operations in the face of market volatility.
Considerations and Limitations
Calculating levered beta for a small business, particularly for owners and entrepreneurs with minimal exposure to financial metrics like beta, involves several considerations and limitations. Understanding these factors is crucial for accurately interpreting the results and making informed decisions. Here's a list tailored for small business owners and entrepreneurs:
Capital Structure Complexity: Small businesses often have simpler capital structures, but personal finances and business finances can be intertwined. Differentiating between personal and business debt for the calculation can be challenging.
Changing Capital Structure: Small businesses may undergo rapid changes in their capital structure (like taking on new debt or equity financing), which can make a previously calculated levered beta quickly outdated. This is why recalculating beta at regular intervals in an important practice.
Data Availability: For private companies and small businesses, the public company data used to calculate levered beta may not perfectly reflect the company's risk profile. Adjustments for additional risk associated with the company’s size are typically added to the cost of equity calculation as a “company specific premium” or similarly named adjustment.
Estimation of Debt and Equity Values: Accurately valuing debt and equity for a private company can be difficult. Market values are ideal, but book values are often used as proxies, which may not reflect current market conditions.
Historical Data: Beta is backward-looking, based on historical data. For rapidly evolving small businesses, past performance may not be indicative of future risk.
Industry-Specific Factors: For niche or highly specialized small businesses, industry averages or proxies used to estimate beta may not accurately reflect the unique risks and opportunities faced by the business. This is another case where a premium may be added to the cost of capital to account for this incremental risk.
Market Representation: Choosing an appropriate market index is important for comparison. However, the chosen index might not fully represent the economic environment or sector in which the small business operates.
Reliance on Financial Models: Levered beta is often used in conjunction with financial models like the Capital Asset Pricing Model (CAPM), which have their own assumptions and limitations, potentially compounding inaccuracies.
Tax Considerations: The tax rate used in the levered beta formula impacts the calculation. Small businesses need to use their marginal tax rate, which can vary significantly based on the business structure and location.
Time and Expertise: Calculating and interpreting levered beta requires a certain level of financial literacy and understanding of statistical analysis, which might necessitate seeking professional advice or dedicating time to learning.
For small business owners and entrepreneurs, understanding these considerations and limitations is key to effectively using levered beta and accounting for any incremental risk that may not be captured by the initial calculation. It's important to complement beta analysis with other financial and non-financial risk assessments to get a comprehensive view of the business's risk profile.