In the previous article, we learned about how to calculate the beta of a publicly traded company’s stock.
However, the same method cannot be used for calculating the beta of a company or project that’s not traded in the market. In this article we will see how to calculate the beta of such a company using the pure-play method.
There are two key considerations while estimating the risk of a company: business risk and financial risk.
Business Risk: The business risk is the risk inherent in operating the business and is comparable for companies operating within the same industry. The pure-play method takes advantage of this by starting with taking the beta estimate of a comparable company. Pure-play refers to companies that are in the single line of business.
Financial Risk: This is the risk that arises due to financial leverage, and depends on the actions by the company’s management. The analyst therefore takes the beta of a comparable firm and adjusts it for the financial risk (adjusting for the leverage).
Calculating beta using the pure-play method involves the following four steps:
Step 1: Find a comparable company
The analyst will first find a comparable company with similar business risk.
Step 2: Estimate beta of the comparable company
Once we have a comparable company, the next step is to observe its beta, which can be done using the market model regression method. Many financial websites also publish betas of large public companies.
Step 3: Calculate unlevered beta of the company
The next step is to unlever the beta for the company. This removes the financial risk element from beta. This is done using the following formula:
Step 4: level the beta for the company’s financial risk
The next step is to estimate the beta of the company or the project. This is done using the following formula:
One issue here is that for debt equity ratio, we only have the book values. The analyst can either use an industry average debt ratio (considering that the firm operates close to other firms in the industry, or it can use an optimal debt ratio based on the operating income and cost of capital.
Assume that we want to calculate the beta of Company A. The following information is available:
|Debt-Equity Ratio for Company A||1.6|
|Debt-Equity ratio of Comparable Company C||1.4|
|Beta of Comparable Company C||1.5|
|Marginal Tax rate||31%|
The Beta of Company A can be calculated as follows:
Unlevered Beta = 1.5/(1+(1-0.31)*1.4= 0.763
Using the unlevered beta, the beta of Company can be calculated:
BetaA = 0.763*(1+(1-0.31)*1.6 = 1.605