Question

1. List and describe two company balance sheet factors which affect the beta of a company’s stock and explain why

Answer 1

A company’s beta is a measure of the volatility, or systematic risk, of a security, as it compares to the broader market. The beta of a company measures how the company’s equity market value changes with changes in the overall market. It is used in the capital asset pricing model (CAPM) to estimate the return of an asset.

Beta, specifically, is the slope coefficient obtained through regression analysis of the stock return against the market return. The following regression equation is employed to estimate the beta of the company:

ΔSi​=α+βi​×ΔM+ewhere:ΔSi​=change in price of stock

  iα=intercept value of the regression

βi​=beta of the i stock return

ΔM=change in the market pricee=residual error term​

Balance sheet Factor affect Beta:

1)DEBT :

How debt affects a company's beta depends on which type of beta (a measure of risk) you mean. Debt affects a company's levered beta in that increasing the total amount of a company's debt will increase the value of its levered beta. Debt does not affect a company's unlevered beta, which by its nature does not take debt or its effects into account. In this article, we'll review the difference between levered and unlevered beta, along with how a company's debt level impacts its beta.

Points :

• A company's debt level impacts its beta, which is a calculation investors use to measure the volatility of a security or portfolio.
• Because unlevered beta removes debt from the equation, the amount of debt a company has does not impact unlevered beta.
• In contrast, the calculation for beta (also known as levered beta or equity beta) includes the impact debt has on the volatility of a company's stock.
• If a company increases its debt to the point where its levered beta is greater than 1, the company's stock is more volatile than the market.
• If a company decreases its debt to the point where its levered beta is less than 1, the company's stock is less volatile than the market.

Levered Beta vs. Unlevered Beta

Beta is a calculation investors use to measure the volatility of a security or a portfolio compared to the market as a whole. Beta measures systematic risk, which is the risk inherent to the market or market segment. Investors use a stock's beta to estimate how much risk the stock might potentially add or subtract from a diversified portfolio.

Beta is also referred to as levered beta or equity beta. When evaluating a company's risk, both debt and equity are factored into the equation to calculate beta. Unlevered beta removes debt from the equation in order to measure the risk due solely to a company's assets.

If a company increases its debt to the point where its levered beta is greater than 1, the company's stock is more volatile than the market. If a company decreases its debt to the point where its levered beta is less than 1, the company's stock is less volatile than the market. If a company has no debt, its unlevered beta and levered beta would be equal.

High Debt and Stock Volatility

Both unlevered beta and levered beta measure the volatility of a stock in relation to movements in the overall market. However, only levered beta shows that the more debt a company has, the more volatile it will be in relation to market movements.

Leverage is the amount of debt a company incurs to fund its assets and growth. For example, a company may borrow money to undertake a project, build a new manufacturing plant, or make an investment it hopes will increase its rate of return.

If a company has more debt than equity, then it's considered to be highly leveraged. If the company continues to use debt as a funding source, its levered beta could grow to be greater than 1, which would then indicate the company's stock is more volatile compared to the market. High volatility means the price of the stock could swing dramatically in either direction over a short time.

2)Asset :

Unlevered beta (a.k.a. Asset Beta) is the beta of a company without the impact of debt. It is also known as the volatility of returns for a company, without taking into account its financial leverage. It compares the risk of an unlevered company to the risk of the market. It is also commonly referred to as “asset beta” because the volatility of a company without any leverage is the result of only its assets.

Equity Beta vs Asset Beta

Levered beta (or “equity beta”) is a measurement that compares the volatility of returns of a company’s stock against those of the broader market. In other words, it’s a measure of risk and it includes the impact of a company’s capital structure and leverage. Equity beta allows investors to gauge how sensitive a security might be to macro-market risks. For example, a company with a beta of 1.5 has returns that are 150% as volatile as the market it’s being compared to.

When you look up a company’s beta on Bloomberg the default number you see is levered, and it reflects the debt of that company. Since each company’s capital structure is different, an analyst will often want to look at how “risky” the assets of a company are, regardless of what percentage of debt or equity funding it has.

The higher a company’s debt or leverage, the more earnings from the company that is committed to servicing that debt. As a company adds more and more debt, the company’s uncertainty of future earnings is also increasing. This increases the risk associated with the company’s stock, but, it is not a result of the market or industry risk. Therefore, by removing the financial leverage (debt impact), the unlevered beta can capture the risk of only the company’s assets.

How do you Calculate Unlevered Beta / Asset Beta?

To determine the risk of a company without debt, we need to un-lever the beta (i.e. remove the debt impact).

To do this, look up the beta for a group of comparable companies within the same industry, un-lever each one, take the median of the set, and then re-lever it based on your company’s capital structure.

Finally, you can use this Levered Beta in the cost of equity calculation.

For your reference, the formulas for un-levering and re-levering Beta are below: