Part – 13
In our last tutorial, we have learnt about estimation of cost of equity.In this article we will find beta for private company.
To find the Beta of a private company, we should first of all find all the listed comparables whose Beta’s are readily available. We will use the average implied Beta of the comparable listed companies to calculate the Beta of the Private company. However, Higher amount of Debt leads to higher variability in earnings (Financial Leverage). Higher financial leverage implies higher sensitivity to the stock prices.. The beta of listed companies includes the effects of leverage and hence, these betas must be unlevered to obtain an unlevered beta. Hence, for comparison of companies within a sector, we should remove the effect of financial leverage (capital structure).
Beta used in CAPM must be calculated by a three step process
Step 1 – Find the observed Beta’s of Comparables.
- Identify a set of comparable listed companies
- Find the Beta from each company’s stock price returns from Bloomberg or other database. This may also be calculated by performing a regression of the stock returns against relevant index returns (regression with the relevant index returns)
If the mean of different companies’ Beta is not meaningful then it must not be used for analysis. This is because the capital structures of different companies may be very different from the Industry structure
Step 2: Calculate the Unlevered Beta of the comparables
Unlevered Beta is calculated using the formula below
For Company 1, the Unlevered Beta Calculation is as follows
This removes the effect of capital structure on a company. This unlevered number can then be relevered to reflect an expected or target level of debt. It is this relevered beta which is used in the CAPM formula.
The average unlevered beta = 0.60
Step 3: Relever the Beta
We then relever the beta at an optimal capital structure as defined by industry parameters or management expectations. The relevered beta is used in the CAPM formula to calculate the cost of equity (Ke). The calculation for the relevered beta is as follows:
Use of gross debt or net debt in beta calculation
In the delevering of the beta of comparable companies, net debt is commonly used instead of gross debt. However, in situations where a company has significant amount of cash in its balance sheet, its beta can be dramatically affected. Therefore, in these circumstances, gross debt has to be used to delever the beta of the company. Subsequently we would have to adjust the obtained Beta (unlevered) to take into account the cash component.
The beta of operating assets would then be used to calculate the beta of the company we want to value.
In this article we have understood how to find beta for private company, now we will understand market risk premium (MRP). Till then, Happy Learning!