Am I overlooking something? If Beta measures only systematic risk (therefore assuming that all firm-specific risk can be diversified away), then why is themodel used to estimate cost of equity? Isn't it a little misleading because some firms with very high firm-specific risk have very low systematic risk?
I'm thinking about biotech stocks vs construction stocks. Biotech stocks have very high firm-specific risk because the product might never be released to the public, but relatively little systematic risk because people need medicine in any business cycle. Construction companies on the other hand have very little firm specific risk, but high systematic risk since they will do poorly if the economy is not doing well. If you use Beta as a measure of risk, though, then the construction company will have a higher Beta than the biotech company due to higher systematic risk even though the biotech company is clearly a "riskier" investment. Why use CAPM used in estimating cost of equity? What am I missing?
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