Discount Rates: III: Relative Risk Measures
Discount Rates: III: Relative Risk Measures
Aswath Damodaran
The CAPM Beta: The Most Used (and
Misused) Risk Measure
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Unreliable, when it looks bad..
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Or when it looks good..
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One slice of history..
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Measuring Relative Risk: You don’t like betas or
modern portfolio theory? No problem.
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Don’t like the diversified investor focus,
but okay with price-based measures
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Don’t like the price-based approach..
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Determinants of Betas & Relative Risk
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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
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In a perfect world… we would estimate the beta of a
firm by doing the following
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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))
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Adjusting for operating leverage…
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Bottom-up Betas
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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))
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.
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Why bottom-up betas?
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Global'firms'in'metals'&'
Metals'&' mining,'Market'cap>$1'
Mining' billion' 48' 0.86' $9,013' 1.97' $17,739' 16.65%'
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
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Embraer’s Bottom-up Beta
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Aswath Damodaran
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Gross Debt versus Net Debt Approaches
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¨ 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
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The Cost of Equity: A Recap
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Aswath Damodaran
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100 Discount Rates: IV
Mopping up
Aswath Damodaran