Unlevering Betas
1. Unlevering Betas
In many cases, the subject firm's beta is estimated using the average or median beta of a set of peer companies. However, different firms have different levels of debt and equity. The more debt a firm has relative to its equity, the riskier the firm is. So we have to first convert the peer betas as if the firms did not carry any debt, which is known as an unlevered beta.2. Unlevering Beta using the Hamada Formula
We unlever betas using the Hamada formula. You first get the peer firm's levered beta - the beta from the regression - that is beta-L in the formula. You then divide it by the denominator, which requires an estimate of the corporate tax rate and the peer firm's debt-to-equity ratio. Note that the debt-to-equity ratio uses market capitalization for the equity. Although the debt part should also be in market value terms, the book value is often used. Why? Because for most firms that are of decent financial health, the book value and market value of debt do not differ substantially. Once we get the Unlevered Betas for the set of comparable companies, we can take the average or median. Then, we take that median or average Unlevered Beta and apply it to the Relevering Formula at the bottom of the slide. The notable difference here is that the debt-to-equity ratio that we relever the beta with is the subject firm's "target" debt-to-equity ratio. The median or average peer company debt-to-equity ratio is often used as the target debt-to-equity ratio for the subject firm, based on the assumption that firms in the same industry will gravitate towards the average firms' debt-to-equity ratio in the long-run.3. Unlevering Beta using Fernandez Formula
Although the Hamada Formula is simple and easy to implement, it rests on the assumption that debt betas are zero. This means that all risk that is passed on to equityholders because the Hamada Formula assumes debtholders hold risk-free debt. However, this is empirically not true because regardless of credit rating debt betas are almost always not equal to zero. One such formula that takes into account debt betas is the Fernandez Formula. The corresponding Fernandez Formulas for unlevering and relevering betas are laid out on the slide. Note that the Fernandez Formula and Hamada Formula are identical when the debt beta is equal to zero. The Fernandez Formula looks a little more complicated than the Hamada Formula but its application is equally as straight-forward with the only exception of estimating the debt beta. Because of liquidity issues for most corporate bonds, one approach to estimate debt betas is to regress the returns of an index of bonds with the same credit rating as the firm's credit rating on the returns of the S&P 500 Index.4. Betas Used in Valuation
You can use the beta estimated based on the subject firm's return when estimating the cost of equity, but it is also common to use a beta estimated from peer companies. There are some advantages when using the peer company approach. The use of peer companies mitigates the effect of firm-specific factors on the estimation of beta and yields a more stable long-run estimate. However, it may be a good idea to use both to test the sensitivity of the results. If they are similar, you will be more confident with your results. If not, then you have to investigate further before making a decision.5. Let's practice!
We just went through a lot of material. Now, let's practice to make the ideas more concrete.Create Your Free Account
or
By continuing, you accept our Terms of Use, our Privacy Policy and that your data is stored in the USA.