Understanding Unlevered Beta
BETA is a measure of market risk. Unlevered beta (or asset beta) measures the market risk of a company without the impact of debt.
‘Unlevering’ a beta removes the financial effects of LEVERAGE thus isolating the risk due solely to a company’s assets. In practical terms, unlevered beta shows how much the company’s equity contributes to its risk profile, excluding debt’s influence.
Key Takeaways
- Levered Beta: Measures a company’s market risk factoring in both debt and equity.
- Unlevered Beta: Strips off the debt component to isolate risk due solely to company assets.
- Debt-to-Equity Ratio Impact: A higher debt-to-equity ratio usually translates to increased risk in the company’s stock.
- Risk Metrics: A beta of 1 means the stock is as risky as the market; values greater or lesser denote higher or lower risk respectively.
Calculating Unlevered Beta
Beta is the slope of the coefficient for a stock regressed against a benchmark market index. Levered beta measures the risk of a firm with debt and equity in its capital structure. In contrast, unlevered beta removes both the beneficial and detrimental impacts due to leverage.
Here is the equation for Unlevered Beta:
$$Unlevered\ Beta = \frac{Levered\ Beta}{1 + ((1 - Tax\ Rate) \times Debt/Equity)}$$
Analyzing a company increasing its debt raises its debt-to-equity ratio. Launching more earnings towards debt servicing amplifies investor concerns about future earnings. Consequently, unlevered beta isolates the risk due to company assets alone, omitting debt’s influence. Unlevered beta indicates asset sensitivity to the market, treating a company like it has no debt. Analysts can effectively compare different companies against each other or the market.
Example of Unlevered Beta Calculation
Consider the calculation for Tesla, Inc., as of November 2017:
- Levered Beta (B~L~): 0.73
- Debt to Equity Ratio (D/E): 2.2
- Corporate Tax Rate: 35%
Using the formula:
$$Tesla\ B~U~ = \frac{0.73}{1 + ((1 - 0.35) \times 2.2)} = 0.30$$
Unlevered beta typically equals or is lower than levered beta, given that debt is generally zero or positive.
Harnessing Unlevered Beta for Investment Decisions
Unlevered beta isolates the risk profile of a company by excluding the debt component, allowing for clearer risk assessment when acquiring stock. Given the differing capital structures among companies, unlevered beta facilitates effective comparisons both with one another and against market benchmarks.
What Is Beta?
Beta (β) fundamentally measures market risk or volatility—a metrics comparing a security or portfolio’s behavior to the market overall. Beta 1 implies equal risk with the market. Beta > 1 implies higher volatility than the market, and Beta < 1 suggests less market volatility.
Understanding Levered Beta
Levered beta gauges a firm’s market risk, incorporating both debt and equity. It reflects the sensitivity of a security’s tendentious performance relative to overall market volatility. Summary metrics: Positive 1 / Negative 1 align stability or invariance. Beyond these values reflect increased volatility relative to the market.
Related Terms: beta, levered beta, systematic risk, volatility, debt-to-equity ratio.
