The business beta measures the risk of a firm relative to a market index. The business beta is applied to an observed market risk premium to arrive at the return equity investors require, over and above a risk-free return. The higher the beta, the riskier the future cash flows.
The business beta reflects the industry sector(s) the business operates in and the financial gearing and operating leverage of the firm.
Business sector beta
If the private business is valued on the basis that the investor is unable to diversify away firm-specific risk, then the business valuer uses a total beta. Total beta reflects both market-risk and firm-specific risk. If the investor can diversify away risk, the regular market betas are appropriate.
The business valuer can estimate a private business beta by obtaining betas for comparable public companies that operate in the same industry sector.
If the business being valued operates in multiple sectors, then the valuer obtains betas for comparable companies in those different sectors and attaches a relevant weighting.
To estimate the private business beta, Professor Damodaran(1) suggests the valuation expert use the simple average beta across the comparable companies.
One of the professor’s arguments for using the average beta is that it produces a more accurate than using individual betas. Each individual company beta is estimated with a standard error, whereas the standard error for the average of across the comparables is lower, relative to the square root of the number of companies in the analysis.
As an example, you want to value a private manufacturing and retail business, operating in the consumer durables market. You assume the investor is investing all their wealth in the business and is unable to diversify away firm-specific risk and consequently, you use a total beta.
You analyse listed ASX companies that operate in the consumer durables and retail industries and identify the following companies that you consider comparable to the private business.
The average total beta across those comparable companies is 4.55
Financially ungeared beta
Financial gearing refers to the extent debt is used to fund the business. The greater the debt burden, relative to the equity in the business, the greater the risk and the higher the beta.
Higher debt results in increased interest repayments and reduced operating income. Higher gearing leads to volatility in earnings.
To establish a business beta that reflects the firm’s financial gearing, the average comparable beta is first adjusted down for the average tax rate and average debt-to-equity ratio for the comparables. This provides an ungeared sector beta*.
In the example, the average ungeared beta across the comparables is 3.58. This is arrived at by taking the average beta for the comparable of 4.55, and dividing it by (1+(1-0.20)(0.34)). Where 0.20 is the average tax rate and 0.34 the average debt to equity ratio across the comparables.
Operating levered beta
Operating leverage refers to a firm’s ability to convert revenue into operating income. The higher the operating leverage, the riskier the operating income and so the higher the beta.
A measure of operating leverage is the firm’s exposure to fixed costs, relative to variable costs. High overheads compared to variable costs, represents a risk. The business needs to generate higher revenue to cover the overheads.
To establish a business beta that reflects the firm’s operating leverage, the average ungeared comparable beta is first adjusted down for the average comparable operating leverage.
In the example, the comparable companies have an average operating leverage of 0.56. To calculate the operating unlevered beta, the ungeared beta of 3.58 is divided by (1+(0.56). This results in an operating unlevered beta for the comparables of 2.29.
The operating unlevered comparable beta is then adjusted back at the firm’s actual operating leverage, to provide an ungeared business beta. In the example, the operating leverage of the private business is 0.38, this is lower than the average for the comparable companies of 0.56.
To calculate the ungeared beta for the private business, the unlevered beta for the comparables of 2.29 is multiplied by (1+0.38), which results in an ungeared beta of 3.15.
Geared business beta
To arrive at the final business beta the ungeared business beta is regeared up to the firm’s actual debt to equity ratio.
In the example, the ungeared business beta of 3.15 is multiplied by (1+(1-.275)(1.27)), where the firm’s tax rate is 0.275 and the firm’s optimal debt to equity ratio is 1.27, to arrive at a geared beta for the firm of 6.04.
1. Damodaran, A, Investment valuation, tools and techniques for determining the value of any asset, Wiley Finance, second edition, page.197
*A financially ungeared beta in corporate finance is referred to as an unlevered beta. I have instead used the term ungeared beta here to distinguish it from the operating unlevered beta.
Simon is a CA Business Valuation specialist, Chartered Accountant and a Certified Fraud Examiner. Simon specialises in providing valuation services. Prior to founding Lotus Amity, he was a Corporate Finance and Forensic Accounting partner with BDO Australia. Simon provides valuation services in disputes, for raising finance, for restructuring, transactions and for tax purposes.
Copyright © 2018 Lotus Amity Pty Ltd. All rights reserved. This article is the property of the author. This article is intended for general information purposes only and is not intended to provide, and should not be used in lieu of, professional advice. The publisher assumes no liability for readers’ use of the information herein and readers are encouraged to seek professional assistance about specific matters.
Lotus Amity | Business Valuations | Forensic Accounting | 0432 617121