Debt Beta: Definition, Formula, Calculation, vs Equity Beta

Discount rates are a key input to investment appraisals, asset valuations, profitability assessments and the setting of regulated revenue allowances. Lastly, beta is typically based on the historical average financial leverage (i.e. capital structure) over the regression period, rather than the current debt-to-equity mix. When it comes to unlevered beta, you can essentially assume that the company is financed entirely with equity with no debt financing – and all free cash flows (FCFs) belong to equity holder(s). If the unlevered beta is positive, investors will invest in the company’s stock when prices are expected to rise.

Below is an example analysis of how to switch between Equity and Asset Beta. Let’s analyze a few of the results to illustrate better how it works.

Beta

The recent six-year data shows that Coca-Cola and S&P 500 have a covariance of 14.15, and the variance of Coca-Cola is 26.59. Let us take, for example, an investor who wants to calculate the beta of Nike compared to the S&P 500. Based on recent six-year data, Nike and S&P 500 have a covariance of 18.75, and the variance of Nike is 48.06.

However, even in a healthy market and with a financially healthy borrower, there is a small probability of default, and so theoretically, the debt beta is not precisely zero but very close to zero. Once you have computed the equity and market returns in each period, you will compute the variance equity beta and asset beta of the market and the covariance of the stock and the market. You can use any tool or software like R, Python, Microsoft Excel, etc. to do these computations. You only need to apply variance and covariance formulas on each period’s equity returns and market returns using software/tool.

Understanding Unlevered Beta

If the slope of Google returns is more than 1, its returns tend to increase or decrease more than the market returns. An asset beta is important because you can compare companies and not have the comparison be affected by capital structure choices. Stock 2 has no cash and no debt, so the equity and asset betas are the same. This makes perfect sense since there is no capital structure impact on the returns.

• In the next section, we’ll calculate the levered beta using the formula we went over earlier.
• The equity beta is also referred to as the market risk of that equity because it is measured in relation to the market.
• Unlevered Beta is a financial metric that analyzes volatility with respect to the overall market.

The differences will depend on parameters such as the debt beta and the tax rate. His next assignment is valuation of Bolan Electric Arts (BEA), a company engaged in production of electric vehicles. Since BEA stock is not publically traded, he cannot estimate beta coefficient by regressing stock return on index return. He wants to unlever and relever equity beta of a similar company, Tesla Motors Inc (TSLA), and has requested you to calculate unlevered beta for TSLA. ‘Unlevering’ the beta removes any beneficial or detrimental effects gained by adding debt to the firm’s capital structure. Of course, the market model regression is well-suited for estimating betas of listed companies.

Types of Beta

An analyst will generally select an index most appropriate to compare with the chosen stock. For instance, the S&P 500 (Standard & Poor’s 500) can be used to calculate the beta of a large U.S. company. Unlevered Beta does not take into account the level of Financial Leverage (i.e., Debt) and risk profile of a company.

Along the same lines, a stock with an equity beta of less than one will have lower volatility than the market. For example, an equity beta of 0.5 indicates that if the market moves up by 10%, this stock will increase by only 5% (10% x 0.5). On the other hand, if the market drops by 5%, this stock will drop by only 2.5% (-5%0.5). A stock with an equity beta lower than one will have lower volatility than the market. Because of the assumption that debt has a constant value, this formula is not appropriate if a firm follows a constant leverage policy—i.e.

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A levered beta between negative 1 and positive 1 has less volatility than the market. Unlevered beta removes any beneficial or detrimental effects gained by adding debt to the firm’s capital structure. Comparing companies’ unlevered betas give an investor clarity on the composition of risk being assumed when purchasing the stock. Since companies have different capital structures and levels of debt, an investor can calculate the unlevered beta to effectively compare them against each other or against the market.

However, beta is a measure of risk relative to a specific market. Whereas variance and standard deviation are measures of volatility as measured against the expected value. Some stocks increase the potential risk of a portfolio while others reduce the risk. Also, there are some stocks which move in the opposite direction from the market having a negative beta. We learned all about the basics of beta and the calculation of beta in this blog.