1. Beta and Industry Beta
Let's take a second to talk about beta a little further.
We can observe or calculate an individual company's beta,
however, the company's beta might not be meaningfully impacted by the overall
stock market, which we can tell by reviewing the R squared.
R squared measures how well the data fit the statistical regression model,
in other words, the goodness of fit. The higher the R squared,
the better the relationship of the stocks returns with that of the market's
returns. If the R squared is low, we might opt to use an
industry beta instead. Due to the low R squared
and the fact that beta is measured with an error term,
we can improve our beta calculation by calculating an industry beta.
However, since different companies in an industry have different capital
structures, we need to unlever each company's beta,
take the average or median of the unlevered betas,
and then relever that number to reflect the target company's capital structure.
You can see the formulas for un levering beta and then re levering
beta. We will work through a comprehensive cost of capital example shortly.
2. Let's practice!