Beta?! Not just Beta - The Levered Beta!

A small valuation quiz: Two companies. Both sell the same products. Both have the same annual income, the same operating profit, and the same number of employees.

Do both have the same value?

The answer - is not necessary! Why? Because of the Levered-Beta (Known also as the Leveraged Beta).

What is Beta?

Beta describes the firm's sensitivity to what is happening in the market.

For example - what will happen to the firm when the economy goes from recession to growth, or vice versa - from recession to recession? Will the firm's profits increase or decrease?

For a company with a beta equal to 1.5, the firm is more sensitive to economic conditions. When the rest of the economy grows by 10% in a particular year, the firm's profits will increase by 15%. If the economy's economic activity is reduced by 10% per year, the company's profits are reduced by 15% per year.

The higher the firm's Beta, the more sensitive the firm will be considered. For example, a firm with a beta of 1.5 will be regarded as more sensitive than a firm with a beta of 0.5.

you can read more about the Beta here.

What Factors Affect the firm's Beta?

Two factors will affect the firm's Beta:

Factor #1: The industry in which the firm operates 

Factor #2: The financial leverage of the firm

The industry in Which the Firm Operates

Industries can be divided into two main groups - aggressive and defensive sectors.

Aggressive industries are more sensitive to the market situation—for example - real estate, aviation, and automobile.

Companies in these industries will only prosper when their customers have money. In other words, in flood in the economy. When there is a recession - companies in these industries will go into recession.

Defensive industries are industries that are less sensitive to the state of the economy. For example - insurance or basic food. Companies in these industries - will be less affected by the economic situation - since people need food all year round, and they will always insure their vehicles and apartments.

Therefore - the company's activity - belonging to one or another industry can affect the company's Beta.

When considering only the industry - the sensitivity is examined using what is known as Unlevered Beta.

The Unlevered-Beta (Known also as Unleveraged-Beta) is related to systematic risk.

You can read more about systematic risk here.

The Financial Leverage of The Firm

Financial leverage is defined as the ratio between foreign capital and equity.

If, for example, the firm has 200 USD in loans, and the company's shareholders have invested 100 USD, the financial leverage is equal to 2.

The higher the financial leverage, the more interest the firm will pay. Therefore the net profit will decrease.

This means that the firm's sensitivity to what is happening in the economy (the Beta) will be higher.

This sensitivity is measured using Beta, known as Leveraged-Beta.

You can read further about Financial Leverage here.

The formula for the Leveraged Beta:

BL = BU( 1 + (1-Tc)*D/E)

Where 

BL = Leveraged-Beta.

BU = Unleveraged-Beta

TC= Corporate Tax Rate

D = Debt

E = Equity

Conclusion

In this blog post, we have discussed the Leverage Beta. If you are looking for a quick and reliable way to test the value of a company - you are welcome to use Equitest. Start for Free by clicking here.