Definition of Unlevered Beta
Unlevered Beta, which is sometimes also known as asset beta, is the measure of the sensitivity of the stock to its relevant market or index consisting of its peers after removing the effect of debt or leverage from its total risk and thereby narrowing down the risk sources to only equity or the assets of the company.
Following is the formula for calculating the Unlevered Beta:
Levered beta is sometimes referred to as Equity Beta also, therefore we should not get confused if this terminology is used thinking it refers to unlevered beta as it is sourced through equity financing only.
- Beta measures the degree of sensitivity of the stock’s returns to the returns of the market and therefore is calculated by regressing the stock’s return to the market returns over a given period of time. We can say that it is the slope of the stock returns with respect to the market returns.
- When we include the debt of the company while calculating the beta, it is known as the Levered Beta, while if we do not include the debt, then the beta arrived at is called the asset beta or the unlevered beta.
- The reason why this is calculated is that the investors want to know how risky it is to invest in the given stock due to market movements. But when we include leverage, we also include the risk that leverage imposes by reducing the net income available to shareholders and also brings in some benefits such as that of the tax shield. But none of these has anything to do with market movements and the purpose of the analysis is to segregate the impact of market movements.
Examples of Unlevered Beta (With Excel Template)
Let’s take an example to understand the calculation in a better manner.
Suppose we are given the following data, for the stock of a company in the banking sector and therefore the relevant market for this stock is a banking index:
Unlevered Beta is calculated using the formula given below
Unlevered Beta = Levered Beta / (1+ (1 – Tax Rate) * (Debt/Equity))
- Unlevered Beta = 0.7 /(1+ (1- 30%) * 2.5)
- Unlevered Beta = 0.25
The unlevered beta can at max be equal to the Levered beta or it can be lower, that is the case when the Debt is equal to zero that is, the company is completely equity financed.
- However, suppose the Debt is negative, which is the case when the business becomes ‘Cash cows’ the unlevered beta can become higher than the levered beta
- If beta is negative, then it is a good stock for portfolio diversification because its returns move counter-cyclically that is when the returns of the market rise, its returns fall but when the market performs poorly, it has positive returns.
- The value of beta = 1 implies that the stock is equally risky to the market while that of lower than 1 means that the stock is less risky in comparison to the market, which is the case in the above example. At a time when the beta is higher than 1, the stock is riskier than the market and therefore the investors would demand a higher rate of return for investing in such stock in comparison to investing in a stock with a beta of lower than 1, as given in the above example.
Importance of Unlevered Beta
- Facilitates Comparison: Unlevered beta assumes that the companies have no debt and then measures the risk of the stock to the market or an index, therefore companies with varying capital structures can be compared with one another using this metric. This is not the case if we compute the unlevered beta.
- Measure of Systematic Risk: Unlevered beta is a measure of systematic risk for only the assets of the company, which is the risk faced by all the companies together, instead of that of a single company arising out of the company-specific factors. Systematic risk measures the risk of the industry or the sector or the economy as a whole.
- Used for Measuring the Risk of Private Companies: In the case of valuing a private company, we use the levered beta of a company that is similar to it and is publicly trading. We then remove the effect of leverage from it by applying the above equation and then use the private company’s debt to equity ratio if any to calculate the beta for the private company. This method is known as the Pure play method.
Unlevered Beta vs Levered Beta
- Inclusions: Levered beta includes the debt component of the company while the unlevered beta removes the same, therefore, the levered beta includes the benefits and limitations related to debt financing while the unlevered beta only considers the equity portion of the financing.
- Comparison: Levered beta can’t be used to compare companies with different debt to equity ratios while as mentioned above, the unlevered beta helps in comparing such companies. This helps in analyzing companies in the industry without bothering about the capital structure of the company
- Value: Levered beta mostly has a higher value, as it includes the impact of leverage. Therefore it conveys that the stock is exposed to two kinds of risk, one is due to the market movements or the cycles in the economy, while the other is because of the presence of debt in the capital structure as it reduces the amount of net profit available for the equity shareholders. Unlevered beta, on the other hand, has a lower value as it only considers the risk arising from the market movement and ignores the risk pertaining to the leverage in the company. As explained earlier, only when the company has a lot of cash, that is its debt is negative, will the value of Unlevered beta be higher than that of the Levered Beta.
Therefore, we can understand that the Unlevered beta is the beta that removes the impact of debt financing present in the capital structure of the company from the Levered beta of the company and therefore helps in the comparison of stocks having different debt to equity ratios. Further, it is used to narrow down the systematic risk to that arising only due to assets of the company or from the equity source of financing.
This is a guide to the Unlevered Beta. Here we discuss how to calculate along with practical examples. We also provide a downloadable excel template. You may also look at the following articles to learn more –