What is Beta in Finance, and why is it Essential for a Business Valuation?
What is Beta in Finance, and why is it essential for a business valuation?
Are you considering evaluating a business using an excel template without understanding Beta in Finance? Think again!
In statistics, beta is defined as the slope of a straight line.
In Finance - the beta represents how sensitive the stock price is concerning the market price change (index).
The beta measures the return of the stock relative to the market return. For example, when the stock market goes up 1%, and the stock goes up 0.5%, then the stock beta is equal to 0.5. If, on the other hand - when the stock market goes up 1%, the stock goes up 2%, then the stock's beta equals 2.
The beta is usually calculated by running a regression between the market and stock returns.
Why is beta important in valuing companies?
One of the common models for valuing companies is the discounted cash flow model - DCF. To evaluate a company's value, using the cash flow discounting method, the future cash flows that the firm will generate must be estimated and capitalized at a discount rate appropriate to the firm's risk.
The firm's risk assessment is done by calculating the weighted average capital price, which weighs the cost of debt (foreign capital) and the cost of equity.
The price of equity represents the return shareholders demand on an investment in the company. For example - if they invest in a startup company, they expect a return of thousands of percent. If, on the other hand, they invest in a less risky business, such as a store, they will expect a much lower return, a few percent every year.
If you do not know the beta, you cannot calculate the equity cost and, as a result, not the weighted average equity price. And if it is not possible to calculate the weighted average capital price - it is not possible to estimate the value of the company according to the DCF method
It is customary to calculate the weighted average capital price using a financial model formula known as the CAPM (Capital Asset Pricing Model).
According to the CAPM model - the return required by the shareholders can be described using the following equation:
Cost of Equity = Risk-Free Rate + Beta x Risk Premium
That is - if you do not know the beta, you cannot calculate the equity cost and, as a result, not the weighted average equity price. And if it is impossible to calculate the weighted average capital price, it is impossible to estimate the company's value according to the DCF method.
So how do you calculate the beta?
The explanation we gave at the top of the article seems complex, and for a good reason. However, there are simple ways to estimate the company's value according to the DCF model.
Those who evaluate a company using the equitest software do not need to put in too much effort when applying the DCF model. He can automatically receive the beta by selecting the country and industry in which the company operates.
The Levered Beta
There are also other types of beta, such as the Leverage Beta (none also as Levered Beta). You can read about it here.
