1. Industry Beta
So because of the low R squared in the WACC example,
we might be able to improve our beta estimate by calculating an industry
beta. So basically we need to find industry comps for our target company.
However, we cannot simply take the average or median beta from these peers.
While a certain amount of debt can be good for a business,
a lot of debt can increase the riskiness of a business
and therefore increase beta. So due to differences in capital structures,
we need to unlever each peer company's beta.
Basically, we have to remove the impact of debt on beta,
hence what we mean when we say we will unlever beta.
So let's work through an example. Here you can see we have three
comps. We have the debt, and equity, and the average tax rate.
Let's calculate the debt and equity for each one of these companies.
So we can simply take debt divided by equity. We'll copy it down, and
we'll go ahead and paste special. So Alt E S is the shortcut I
like to use to pull up paste special. And we just want to
paste the formulas. So you can just press F
and then hit okay. And the reason why we decided just to paste
the formulas is so that we didn't mess up any of the borders.
So next you can see that we have the levered beta.
Again, you can get this from a financial subscription service like Bloomberg
or Capital IQ. You might be able to find it on Yahoo Finance
or some other free platforms. But those are the levered betas,
so those already take into account the peer company capital structure.
And we want to remove the impact of that capital structure on these
peer companies. So we will unlever them. And the formula is at the
bottom. So we're going to take our levered beta. We'll divide.
We'll open one[we'll do one plus, then we'll open up another bracket,
one minus the peer company tax rate]. And then we'll multiply that
by that peer company's debt to equity. We have one more bracket to
close for the denominator, press enter, and we get 0.9.
One thing to note is that your unlevered beta should be lower than
your levered beta. Again, debt increases beta. So when we remove the impact
of debt through our unlevered beta calculation, our unlevered beta should
be lower. So again, we'll copy that, and then we'll paste special,
all ESF for formulas. So we can then calculate the average unlevered beta
in this case, but we could also use the median if there are
outliers or lots of peer companies. But we'll just stick with the average
in this case. And again, quick Excel trick shortcut effectively.
Start typing in a function name. You get a list of the functions
that begin with AV. Down arrow once to select average and hit Tab.
And it fills in the rest of the function name with the open
bracket. So we'll select our unlevered betas. We'll press enter. So the
average unlevered beta is 0.89. So now we take that
average industry unlevered beta, and then we relever it according to the
target company's capital structure and tax rate. We've provided
the target company debt to equity ratio, or it's really a target.
And we're assuming a 25% tax rate in this case. Again,
the levered beta or the relevering beta formula is below.
So we'll take our industry average unlevered beta. We'll multiply it.
Open bracket, one plus, another open bracket, one
minus the target company tax rate, close that bracket.
We'll multiply it by the target debt to equity ratio,
close the final bracket. Press enter. And now our levered beta,
again, based on industry comps is 0.99. Again,
we might want to do this if the R square isn't very high
in the beta that we calculated. And using an industry beta also reduces
the standard error that is calculated with any regression.
So this is a best practice when calculating beta using an industry beta
as opposed to an individual company's beta. One final point to make,
we aren't going to replace the beta we calculated on the WACC tab
with this levered beta. We just wanted to show you the process of
calculating an industry beta and when and why we might do that.
2. Let's practice!