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Discount Rates: III: Relative Risk Measures

The document discusses various methods for estimating the beta of a stock or firm. It begins by describing the standard CAPM method of regressing stock returns against market returns to obtain a beta. However, it notes this beta has problems like high standard error and may not reflect the firm's current business mix or leverage. The document then discusses alternative risk measures and approaches to adjusting the beta for factors like a firm's operating leverage, financial leverage, industry, and individual business segments.

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0% found this document useful (0 votes)
103 views20 pages

Discount Rates: III: Relative Risk Measures

The document discusses various methods for estimating the beta of a stock or firm. It begins by describing the standard CAPM method of regressing stock returns against market returns to obtain a beta. However, it notes this beta has problems like high standard error and may not reflect the firm's current business mix or leverage. The document then discusses alternative risk measures and approaches to adjusting the beta for factors like a firm's operating leverage, financial leverage, industry, and individual business segments.

Uploaded by

Elli
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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81 Discount Rates: III

Relative Risk Measures

Aswath Damodaran
The CAPM Beta: The Most Used (and
Misused) Risk Measure
82

¨ The standard procedure for estimating betas is to regress


stock returns (Rj) against market returns (Rm) -
Rj = a + b Rm
where a is the intercept and b is the slope of the regression.
¨ The slope of the regression corresponds to the beta of
the stock, and measures the riskiness of the stock.
¨ This beta has three problems:
• It has high standard error
• It reflects the firm’s business mix over the period of the
regression, not the current mix
• It reflects the firm’s average financial leverage over the period
rather than the current leverage.

Aswath Damodaran
82
Unreliable, when it looks bad..
83

Aswath Damodaran
83
Or when it looks good..
84

Aswath Damodaran
84
One slice of history..
85

During 2019 and 2020, GME was an


extraordinarily volatile stock, as short
sellers and long only investors fought
out a battle.
Aswath Damodaran
And subject to game playing
86

Aswath Damodaran
Measuring Relative Risk: You don’t like betas or
modern portfolio theory? No problem.
87

Aswath Damodaran
87
Don’t like the diversified investor focus,
but okay with price-based measures
88

1. Relative Standard Deviation


• Relative Volatility = Std dev of Stock/ Average Std dev across all stocks
• Captures all risk, rather than just market risk
2. Proxy Models
• Look at historical returns on all stocks and look for variables that
explain differences in returns.
• You are, in effect, running multiple regressions with returns on
individual stocks as the dependent variable and fundamentals about
these stocks as independent variables.
• This approach started with market cap (the small cap effect) and over
the last two decades has added other variables (momentum, liquidity
etc.)
3. CAPM Plus Models
• Start with the traditional CAPM (Rf + Beta (ERP)) and then add other
premiums for proxies.

Aswath Damodaran
88
Don’t like the price-based approach..
89

1. Accounting risk measures: To the extent that you don’t trust


market-priced based measures of risk, you could compute
relative risk measures based on
• Accounting earnings volatility: Compute an accounting beta or relative
volatility
• Balance sheet ratios: You could compute a risk score based upon accounting
ratios like debt ratios or cash holdings (akin to default risk scores like the Z
score)
2. Qualitative Risk Models: In these models, risk assessments
are based at least partially on qualitative factors (quality of
management).
3. Debt based measures: You can estimate a cost of equity,
based upon an observable costs of debt for the company.
• Cost of equity = Cost of debt * Scaling factor
• The scaling factor can be computed from implied volatilities.

Aswath Damodaran
89
Determinants of Betas & Relative Risk
90

Beta of Equity (Levered Beta)

Beta of Firm (Unlevered Beta) Financial Leverage:


Other things remaining equal, the
greater the proportion of capital that
a firm raises from debt,the higher its
Nature of product or Operating Leverage (Fixed equity beta will be
service offered by Costs as percent of total
company: costs):
Other things remaining equal, Other things remaining equal
the more discretionary the the greater the proportion of Implciations
product or service, the higher the costs that are fixed, the
the beta. higher the beta of the Highly levered firms should have highe betas
than firms with less debt.
company. Equity Beta (Levered beta) =
Unlev Beta (1 + (1- t) (Debt/Equity Ratio))

Implications Implications
1. Cyclical companies should 1. Firms with high infrastructure
have higher betas than non- needs and rigid cost structures
cyclical companies. should have higher betas than
2. Luxury goods firms should firms with flexible cost structures.
have higher betas than basic 2. Smaller firms should have higher
goods. betas than larger firms.
3. High priced goods/service 3. Young firms should have higher
firms should have higher betas betas than more mature firms.
than low prices goods/services
firms.
4. Growth firms should have
higher betas.

Aswath Damodaran
90
In a perfect world… we would estimate the beta of a
firm by doing the following
91

Start with the beta of the business that the firm is in

Adjust the business beta for the operating leverage of the firm to arrive at the
unlevered beta for the firm.

Use the financial leverage of the firm to estimate the equity beta for the firm
Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (Debt/Equity))

Aswath Damodaran
91
Adjusting for operating leverage…
92

¨ Within any business, firms with lower fixed costs (as a


percentage of total costs) should have lower unlevered
betas. If you can compute fixed and variable costs for
each firm in a sector, you can break down the unlevered
beta into business and operating leverage components.
¤ Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable
costs))
¨ The biggest problem with doing this is informational. It is
difficult to get information on fixed and variable costs for
individual firms.
¨ In practice, we tend to assume that the operating
leverage of firms within a business are similar and use
the same unlevered beta for every firm.
Aswath Damodaran
92
Adjusting for financial leverage…
93

¨ Conventional approach: If we assume that debt carries


no market risk (has a beta of zero), the beta of equity
alone can be written as a function of the unlevered beta
and the debt-equity ratio
bL = bu (1+ ((1-t)D/E))
In some versions, the tax effect is ignored and there is no (1-t) in
the equation.
¨ Debt Adjusted Approach: If beta carries market risk and
you can estimate the beta of debt, you can estimate the
levered beta as follows:
bL = bu (1+ ((1-t)D/E)) - bdebt (1-t) (D/E)
While the latter is more realistic, estimating betas for debt can be
difficult to do.

Aswath Damodaran
93
Bottom-up Betas
94

Step 1: Find the business or businesses that your firm operates in.

Possible Refinements
Step 2: Find publicly traded firms in each of these businesses and
obtain their regression betas. Compute the simple average across
these regression betas to arrive at an average beta for these publicly If you can, adjust this beta for differences
traded firms. Unlever this average beta using the average debt to between your firm and the comparable
equity ratio across the publicly traded firms in the sample. firms on operating leverage and product
Unlevered beta for business = Average beta across publicly traded characteristics.
firms/ (1 + (1- t) (Average D/E ratio across firms))

While revenues or operating income


Step 3: Estimate how much value your firm derives from each of are often used as weights, it is better
the different businesses it is in. to try to estimate the value of each
business.

Step 4: Compute a weighted average of the unlevered betas of the If you expect the business mix of your
different businesses (from step 2) using the weights from step 3. firm to change over time, you can
Bottom-up Unlevered beta for your firm = Weighted average of the change the weights on a year-to-year
unlevered betas of the individual business basis.

If you expect your debt to equity ratio to


Step 5: Compute a levered beta (equity beta) for your firm, using change over time, the levered beta will
the market debt to equity ratio for your firm. change over time.
Levered bottom-up beta = Unlevered beta (1+ (1-t) (Debt/Equity))

Aswath Damodaran
94
Why bottom-up betas?
95

¨ The standard error in a bottom-up beta will be significantly


lower than the standard error in a single regression beta.
Roughly speaking, the standard error of a bottom-up beta
estimate can be written as follows:
Std error of bottom-up beta = Average Std Error across Betas
Number of firms in sample

¨ The bottom-up beta can be adjusted to reflect changes in the


firm’s business mix and financial leverage. Regression betas
reflect the past. €

¨ You can estimate bottom-up betas even when you do not


have historical stock prices. This is the case with initial public
offerings, private businesses or divisions of companies.
Aswath Damodaran
95
Estimating Bottom Up Betas & Costs of
Equity: Vale
Sample' Unlevered'beta' Peer'Group' Value'of' Proportion'of'
Business' Sample' size' of'business' Revenues' EV/Sales' Business' Vale'

Global'firms'in'metals'&'
Metals'&' mining,'Market'cap>$1'
Mining' billion' 48' 0.86' $9,013' 1.97' $17,739' 16.65%'

Iron'Ore' Global'firms'in'iron'ore' 78' 0.83' $32,717' 2.48' $81,188' 76.20%'

Global'specialty'
Fertilizers' chemical'firms' 693' 0.99' $3,777' 1.52' $5,741' 5.39%'

Global'transportation'
Logistics' firms' 223' 0.75' $1,644' 1.14' $1,874' 1.76%'
Vale'
Operations' '' '' 0.8440' $47,151' '' $106,543' 100.00%'

Aswath Damodaran
96
Embraer’s Bottom-up Beta
97

Business Unlevered Beta D/E Ratio Levered beta


Aerospace 0.95 18.95% 1.07

¨ Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (D/E Ratio)


= 0.95 ( 1 + (1-.34) (.1895)) = 1.07

¨ Can an unlevered beta estimated using U.S. and European


aerospace companies be used to estimate the beta for a Brazilian
aerospace company?
a. Yes
b. No
What concerns would you have in making this assumption?

Aswath Damodaran
97
Gross Debt versus Net Debt Approaches
98

¨ Analysts in Europe and Latin America often take the difference between
debt and cash (net debt) when computing debt ratios and arrive at very
different values.
¨ For Embraer, using the gross debt ratio
¤ Gross D/E Ratio for Embraer = 1953/11,042 = 18.95%
¤ Levered Beta using Gross Debt ratio = 1.07
¨ Using the net debt ratio, we get
¤ Net Debt Ratio for Embraer = (Debt - Cash)/ Market value of Equity
= (1953-2320)/ 11,042 = -3.32%
¤ Levered Beta using Net Debt Ratio = 0.95 (1 + (1-.34) (-.0332)) = 0.93
¨ The cost of Equity using net debt levered beta for Embraer will be much
lower than with the gross debt approach. The cost of capital for Embraer
will even out since the debt ratio used in the cost of capital equation will
now be a net debt ratio rather than a gross debt ratio.

Aswath Damodaran
98
The Cost of Equity: A Recap
99

Preferably, a bottom-up beta,


based upon other firms in the
business, and firmʼs own financial
leverage

Cost of Equity = Riskfree Rate + Beta * (Risk Premium)

Has to be in the same Historical Premium Implied Premium


currency as cash flows, 1. Mature Equity Market Premium: Based on how equity
and defined in same terms Average premium earned by or market is priced today
(real or nominal) as the stocks over T.Bonds in U.S. and a simple valuation
cash flows 2. Country risk premium = model
Country Default Spread* ( σEquity/σCountry bond)

Aswath Damodaran
99
100 Discount Rates: IV
Mopping up

Aswath Damodaran

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