What it means
Beta is a statistic, usually estimated by comparing a share's past returns with the returns of a broad market index. A share with a beta of 1.2 has, on average, risen 12% when the market rose 10% and fallen by a similar proportion in a decline.
The beta observed in the market for an actual company is its levered beta, because it reflects the way that company is financed. Borrowing makes shareholders' returns more volatile.
Interest has to be paid whatever happens to sales, so a small fall in operating profit becomes a bigger fall in what is left for shareholders. A company with a lot of debt therefore tends to have a higher levered beta than an identical company with none.
Strip the financing effect out and you get the unlevered beta, sometimes called the asset beta, which reflects only the risk of the underlying business. Analysts do this to compare companies with different amounts of debt on a like-for-like basis.
They then re-lever the figure to match the debt level of the company they are valuing. The conversion uses the debt-to-equity ratio and the tax rate, because interest is usually tax deductible and the deduction softens the effect of debt.
The result feeds into the capital asset pricing model, which estimates the cost of equity as a risk-free rate plus beta multiplied by a market risk premium. That cost of equity is then used in valuation and in the weighted average cost of capital.
Betas are estimates, not facts. They change with the time period, the index and the data frequency chosen, and a figure for a company that has changed its business or financing may mislead.
Careful analysts use several estimates and cross-check against betas of comparable firms.
In practice
Real-world examples
Example 1
An analyst values a private chemicals company that has no listed shares. She takes the unlevered betas of five listed peers and averages them. She then re-levers that average at the target debt level of the private company to get its cost of equity.
Example 2
A retail chain plans to borrow heavily to fund a buy-out. The finance team calculates that its levered beta will rise from 0.9 to 1.4 under the new structure. This tells shareholders that they should expect higher returns to compensate for higher risk.
Example 3
A utility has a low beta of 0.5 because customers pay regardless of the economic cycle. A technology start-up in the same index has a beta of 1.6. The two firms are priced very differently, partly for that reason.
Think of it
Imagine driving a car down a winding road. Unlevered beta is the handling of the car itself. Levered beta is how that handling changes when you load the boot with heavy bricks. The extra weight makes every turn feel sharper and riskier.
Formula
Calculation
Levered beta = Unlevered beta x [1 + (1 - Tax rate) x (Debt / Equity)]
Cost of equity = Risk-free rate + Levered beta x Market risk premium
A company's comparable peers suggest an unlevered beta of 0.80. The company will fund itself with $50,000,000 of debt and $100,000,000 of equity, so debt-to-equity is 0.5, and the tax rate is 25%. The adjustment factor is 1 + (1 - 0.25) x 0.5 = 1 + 0.375 = 1.375, so the levered beta is 0.80 x 1.375 = 1.10. With a risk-free rate of 4% and a market risk premium of 5%, the cost of equity is 4% + 1.10 x 5% = 9.5%.Case study
Seen in the real world
Ridgeway Foods is an illustrative, fictional packaged food business that was evaluating a new factory. The finance team needed a discount rate, so it started with the cost of equity. Its own observed beta was 0.95, but it had recently repaid a large loan, so the history overstated its current financial risk.
The analyst unlevered the historical beta at the old debt level and re-levered it at the new, lower debt ratio. The result was a levered beta of about 0.85, which cut the cost of equity by about half a percentage point. That small change pushed the net present value of the factory from slightly negative to slightly positive, a reminder that beta choices can swing close decisions.
Watch out
Common mistakes
- Using a historical levered beta without adjusting for a change in the company's debt level.
- Mixing levered and unlevered betas when comparing companies, which makes the peers look more or less risky than they are.
- Treating beta as a precise number, when it is an estimate that varies with the method and period.
Questions
People also ask
What does a levered beta of 1.5 mean?
It means the share has historically moved about 50% more than the market, in both directions.
Why is levered beta higher than unlevered beta?
Because debt adds fixed interest costs that make shareholder returns more volatile, so equity holders bear more risk.
Where does a company's beta come from?
Data providers estimate it from past share price and market index returns, or analysts derive it from comparable companies.