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Beta Basics What is beta ? Beta measures the sensitivity of an asset with the broader market. For e.g. HLL's returns have a co-movement of 0.9 with that of the SENSEX. i.e. if SENSEX moves up by 1% HLL will move by 0.9% and if SENSEX falls by 2% HLL will fall by 1.8% How is it measured / calculated / estimated ? There are 2 popular approaches - Regression & Covariance method What drives beta ? Economy Industry absolute growth FII / FDI inflow relative growth Cyclicity sustainable growth Government regulation / control foreign threat availability of funds threat from natural calamities Barriers to entry mobilisation of funds threat of substitutes & degree of elasticity currency convertibility degree of competition degree of fragmentation/concentration cartelisation / monopoly / oligopoly / monopolistic competition www.finaticsonline.com ll fall by 1.8% Company absolute growth relative growth sustainable growth risk from operating leverage risk from financial leverage Revenues - fragmented or highly concentrated ? market share of the company & degree of influence Beta Types & FAQs FAQs Levered Unlevered A.k.a Equity beta/Raw beta Operating / Asset beta Variants Re-levered beta (Levered to a companies 'Target' Debt-Equity) Meaning It reflects both types of risks that a It reflects the risk of operations alone shareholder has to bear. i.e. operating and resulting from fixed costs such as financial leverage. The raw beta that one depreciation, rent & salaries. For this r calculates from market data It is also called Asset beta - Risk relate efficient use of assets When do i use it ? Levered/Relevered beta is used when Unlevered beta is used when calculati calculating DCF using Enterprise approach i.e. using Equity approach i.e. from (FCFE) from (FCF) - 'Free Cash Flows to Firm' Cash Flows to Equity' approach Why ? Under Enterprise DCF approach cash flows Under Equity DCF approach cash flow for the firm are calculated (i.e. cash flows equity are calculated (i.e. cash flows le generated by assets, and not a particular type equity shareholders alone). The paym of capital). The payment to each capital each capital provider is already made provider shall be made from this and hence hence the risk of leverage is already fa when discounting this one must capture the into the cash flows. When discounting risk to be borne by residual providers as a cannot consider the risk again and hen result of financial leverage unlevered beta must be used. (i.e. bet risk of financial leverage) How do I calculate it ? It is also called as 'Raw' beta as we calculate it Although academicians have come up directly from market data without any other over 15 methods of Unlevering and re adjustment. There are 2 methods to do the betas Practitioners use only one ! same - Covariance method and Regression. BetaLevered = BetaUn-levered x (1 + D/E) However, for Relevered beta academicians Where, D/E is the Target Debt Equity r suggest Unlevering Raw beta and then relevering it to a theoretical concept called 'Target' capital structure. We suggest that one assumes that the current capital structure would be a fair proxy, as a company will expand when it must from whatever means of funding available 'Target' capital structure. We suggest that one assumes that the current capital structure would be a fair proxy, as a company will expand when it must from whatever means of funding available What is Normalizing ? The beta thus calculated reflects historical performance alone! It is necessary to enco some form of smoothing to reflect forecasted performance. Bloomberg came up wit own smoothing formula what it calls 'Bloomberg Adjusted Beta'. Calculated as 2/3rd o current calculated beta and 1/3rd of Long-term beta i.e. 1 (assuming that at some poin future the company's beta will converge with broader market beta i.e. 1 !).E.g Raw be Bloomber adjusted beta = (0.67 x 0.70) + (0.33 x 1) = 0.79. We think it is better to have 2 betas. One used for discounting Explicit period cash flo the other for continuing value. For the explicit period it is best to assume beta as norm calculated while for continuing value one must consider the Long-term beta i.e. 1. www.finaticsonline.com e risk of operations alone. i.e. risk om fixed costs such as n, rent & salaries. For this reason ed Asset beta - Risk related to of assets eta is used when calculating DCF approach i.e. from (FCFE) - 'Free to Equity' approach y DCF approach cash flows for alculated (i.e. cash flows left for eholders alone). The payment to provider is already made and sk of leverage is already factored h flows. When discounting one ider the risk again and hence eta must be used. (i.e. beta sans cial leverage) ademicians have come up with hods of Unlevering and relevering tioners use only one ! = BetaUn-levered x (1 + D/E) s the Target Debt Equity ratio. ne! It is necessary to encompass . Bloomberg came up with its Beta'. Calculated as 2/3rd of ssuming that at some point in et beta i.e. 1 !).E.g Raw beta 0.70 ng Explicit period cash flows and est to assume beta as normally Long-term beta i.e. 1. Calculating Raw Beta Sensex Stock A 0.09% 0.36% 0.0000621 =COVAR(C4:C24,D4:D24) -0.63% -0.47% 0.0001383 =VAR(C4:C24) 1.05% -0.21% 0.45 =COVAR / VAR =F4/F5 -1.23% 0.64% 1.48% 0.39% 0.4717 =SLOPE(D4:D24,C4:C24) -0.27% -1.71% 0.55% 0.02% 1.81% 1.01% Stock A -0.32% -1.43% 2.00% 0.39% 1.38% 1.50% -1.38% -0.32% 1.00% -1.28% -0.53% 1.84% 1.64% 0.50% -1.37% 0.45% 0.00% 0.20% 0.86% -3.00% -2.00% -1.00% 0.00% 1.00% 1.16% 1.24% -0.50% -1.55% 0.18% -1.00% -1.83% -1.07% -1.50% 0.79% 1.12% -1.47% -1.41% -2.00% -0.17% 1.98% www.finaticsonline.com Note: Data for beta calculation must be for a period of at least 3 years at monthly intervals or use average beta of a comparable set of companies Regression using Market model Stock A Beta = 0.4717 R² = 0.2806 Stock A 1.00% 2.00% 3.00% Unlevering & Relevering Raw Beta / Levered beta / Equity beta 1.3 << As calculated using regression or Current Debt-Equity 27% << Using Market value weights Target Debt-Equity 15% << Using Market value weights. Tip: It is best to look at the capita BU = BL / (1 + D/E) 1.02 << also known as operating beta i.e BRL = BU x (1 + D/E) 1.18 << Relevered based on 'Expected' o Impact of Target Debt on Relevered beta Target Debt/Equity 10% 15% 20% 25% 30% 35% 1.18 1.13 1.18 1.23 1.28 1.33 1.38 www.finaticsonline.com ulated using regression or Co-variance method from market data Market value weights Market value weights. s best to look at the capital structures of mature companies in the same industry own as operating beta i.e. as a result of fixed operating costs such as depreciation, rent and salaries red based on 'Expected' or 'Estimated' Target Debt/Equity 40% 1.43

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posted: | 3/11/2012 |

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