What is Beta in finance? What is levered and unlevered Beta?
We should understand the risk attached before making any financial investment. Beta is one of the major metrics used to measure risk. Beta calculates a security’s volatility with respect to the whole market. It signifies the sensitivity of a security’s returns.
A beta of 1 means that the price of the security will be in relation to the movement in the market. A beta higher than 1 shows more volatility than the market, and a beta lower than 1 indicates lesser volatility.
The beta of the firm carrying debt and equity components within its capital structure is known as levered or equity beta. Levered beta measures how the common stock of a company is affected by the shifting of the overall market, taking into account the impact of the company’s financial structure, including the debt component.
Now, if levered beta is more than 1, it shows that the stock is highly volatile compared to the market, demonstrating that the price of the stock will go up or it will come down as compared to the market.
A levered beta of less than 1 shows that the stock is less volatile according to the market. For example, a levered beta of 1.5 shows that the stock could fluctuate by 150% of the market’s movement, either up or down. The more debt a firm carries, the higher the levered beta tends to be. That is because financially obligated firms are taking on greater risks.
The asset beta, or unlevered beta, captures the market risk of the company without having any impact of debt. The evaluation of the firm’s intrinsic risk may only be obtained in terms of its assets. Removing the effects of debt, the asset beta clearly brings out the intrinsic risks involved in the company’s activities.
It helps in comparing companies having different capital structures on a similar basis. For example, a comparison between two companies may be made such that changing the levels of debt would affect their respective risk profiles. This knowledge of asset beta helps investors make better investment or acquisition decisions as it reflects the true volatility of its operations.
Asset beta also plays an important role in evaluating the cost of equity for valuation models, thereby allowing quantification of a company’s overall value.
Leverage impacts beta by increasing a firm’s equity risk. A firm’s business risk without having any impact of debt is reflected in unlevered beta, meaning its sensitivity to market movements is based purely on operations, but when it uses debt, leveraged beta increases because there is an introduction of financial risk.
Since debt payments of the company are fixed and increase volatility for equity holders, higher leverage results in a higher beta because market conditions add risk to the stock price.
The relationship between levered and unlevered can be shown with the equation.
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| Equation: levered & unlevered Beta |
As leverage increases, equity becomes riskier, making the stock more volatile with respect to the market. Therefore, reducing debt lowers levered beta, decreasing equity risk and making the stock less sensitive to market fluctuations.
Levered v/s Unlevered Beta
- Impact of Debt
The leveraged beta captures the debt of the company, which indicates a higher risk at higher leverage. A firm with a higher debt-to-equity ratio will have a higher levered beta since the company bears more financial obligations. Unlevered Beta, on the other hand, has no impact of debt and is solely impacted by the assets of the firm. This measure helps investors understand the quantity of risk attributed to the operations of the firm rather than to the structure of financing.
- Volatility Measurement:
Equity beta indicates how responsive the returns on the stock are to the market behavior since its value increases with increased volatility. A high equity beta means that the stock will change in price more than the market. Whereas unlevered beta measures the intrinsic risk from the asset side of the company. Thus, it presents a clearer image about the volatility of the assets. Through this, investors are also able to determine the stability level of the core business under the stock.
- Use in Investment Analysis
Levered beta is mainly applied for equity valuation, and it also determines the risks of a firm based on its debt. It portrays the total risk shared by both the equity as well as debt holders. Unlevered Beta mostly examines companies in an industry, irrespective of the capital structure. This helps analysts to actually measure the true risk associated with a firm’s assets, and it frequently appears in capital structure optimization analysis.
Investment banks adjust in capital structure because that would provide a better basis for coming up with a clarified risk profile of the company and better valuations. Capital structure refers to the debt as well as the equity mix that the firm employs to fund itself. It influences financial risk as well as business risk.
Analysts use this practice through the separation of levered beta, which contains debt, from unlevered beta, which excludes debt. This separates the inherent business risk from the company and the additional financial risk arising from borrowing. It then helps determine how much risk arises from the operations and financing choices of the company.
The leverage impacts the cost of capital of a firm; at the same time, debt reduces capital costs because its cost is tax-deductible, while too much debt increases financial risk and therefore increases both the debt and equity costs. Thus, capital structure needs to be adjusted while calculating WACC, and applications of WACC (weighted average cost of capital) are crucial for accurate valuation in DCF (discounting cash flow) models.
By using unlevered beta, companies can compare themselves with other industry benchmarks in order to reach their ideal mix of debt and equity, thus having more enlightened financing decisions. Capital structure leads to better investment choices and sharper prediction of stock returns due to adjustments in capital structure.
Two of the more important finance concepts that allow investors to evaluate the risk about the capital structure of a firm are beta-leveraged and unlevered.
Levered beta, based on financial leverage, deals with a company’s capital structure while balancing the higher risk associated with the liability portion of a firm’s capital structure.
The unlevered beta splits the risk that is only in a firm’s assets and thus facilitates easier comparisons of different firms.
These two measures are therefore critical in the process of decision-making towards providing a well-informed investment decision in a setting where capital structure choices may be very difficult for a firm’s risk profile and valuation overall.
For that reason, investors and analysts both must take into consideration both levered and unlevered beta to properly evaluate the company’s risk exposure as well as its performance potential.