Which beta should we use in different scenarios?

Kevin ZH's picture
Kevin ZH - Certified Professional
Rank: Monkey | banana points 58

What determines our choices of beta when calculating cost of capital?
When should we use levered beta and when should we use unlevered beta?
Besides, say a company has a historical beta, under what circumstance can we just use it instead of using industry beta??

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Comments (8)

Jan 3, 2019

we usually (work at a valuation boutique) use forward looking betas, but understand many banks don't do so.

you get the levered beta when looking for it in any popular internet service. What you want to do after that is to unlever the beta - you want to check what is the risk of the firm should it have no debt and be all equity. After that, in your model, either select the average or the median and relever the beta. You would use that beta to calculate the cost of equity.

In general the industry beta is such median or average (make sure to use some sort of choose function in your model)

Hope this helps?

Jan 3, 2019

Thanks a lot.
Still have a question and would appreciate if you could help.
I always wonder why we usually don't use historical beta.
I understand that we use industry beta(the unlevered one) as it is a benchmark, implying the average/median risk level the of the players in the industry. By levering it with target firm's current or forwarding capital structure, we get the final beta we use in CAPM model.
However, when looking for a benchmark, isn't a firm's historical beta more relevant than the industry one? Why can't we just unlever the firm's historical beta and then lever it with the forwarding equity/debt structure.?

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Jan 3, 2019

Check my recent posts in Unlevered Beta And Levered Beta, Which One Do We Usually Know First

To summarize: you get levered beta from Bloomberg or your own regressions. You unlever the beta's of your peergroup. Take the average/median and subsequently relever with the capital structure of your target company.

If company's activities have changed significantly I agree you could use forward looking beta. Check this website on that under paragraph 4:
http://people.stern.nyu.edu/adamodar/New_Home_Page/AppldCF/derivn/ch4deriv.html

Jan 3, 2019

Thanks a lot.
That discussion was initiated by me. Lol.
A further question:
Why can't we just use the target company's historical beta? If a company's activities have not changed significantly. I think the historical beta can also reflect the risk level the firm bears.

Jan 3, 2019

According to tier 1 b-school finance professor we include peers next to target (assuming target is listed..) because markets are not perfect and the error in the beta as a result of that is more likely to be cancelled out if you increase sample size. I however don't agree because perfect peers don't exist.

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Jan 3, 2019

Thanks a lot!
So, in your opinion, historical beta for a target company might be better than its peer's beta? (I guess especially when similar peers are hard to find?)

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Jan 3, 2019

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Jan 3, 2019