Unlevered beta
Key Takeaways:
- Beta measures the market risk of a company
- A beta with its value equal to 1 represents that the stock price will move with the market
- Unlevered beta is the beta of a company, after eliminating the effects of financial leverage
- Unlevered beta is also known as asset beta
What is Beta?
Beta measures the market risk of a company but can also be used to compare companies in the same industry. While calculating the beta of a company which is publicly traded is easy as the returns of the company and of the market are known, doing the same for unlisted companies is not as straightforward.
A comparable listed company is one which faces similar business risks as the unlisted company for which we are calculating beta.
What is unlevered Beta?
Unlevered beta, also known as asset beta, is the beta of a company, after eliminating the effects of financial leverage. It is also called asset beta because the risk is only due to its assets, as the debt part is removed. Unlevered beta is often used for a company which is not publicly traded, using the pure play method. Unlevered beta can be found out by removing the debt component from the levered beta.
Levered Vs Unlevered Beta
Levered beta, or simply beta, calculates the systematic risk of a company with respect to the market. Systematic risk is the risk that affects the whole market and is not confined to a specific company or industry. Levered beta does not throw light on unsystematic risk, a risk confined to a particular stock that can be mitigated by diversification. Levered beta focuses on the risk a company has due to leverage.
Levered beta is not useful when comparing two companies with quite different capital structures. In such a scenario, it is required that the debt effect is removed. This is done by “unlevering” the beta, and the beta thus obtained is called unlevered beta.
Formula to calculate Unlevered Beta
Unlevered Beta can be calculated using the formula:
Unlevered Beta = Levered Beta/[1+{1-Tax Rate}*Debt/Equity]
Pure Play Method
The pure play method is a calculation which takes a comparable but listed company, and unlevers its beta (which means eliminating the effects of financial leverage in its beta and relevering with the leverage the private company has) to get the unlisted company’s risk quotient or beta. It can be divided into following steps:
1. Find out a comparable company
2. Calculate the beta of the comparable company
3. Unlever the beta of the comparable company using the formula given earlier
4. Relever the beta with the capital structure of the concerned company.
Let us consider an example to understand the process better. Let’s consider that a private and unlisted company A has the following capital structure and you need to calculate the beta of company A.
| Total Debt | $4 million |
| Total Equity | $10 million |
| Debt to Equity Ratio | 40% |
| Tax Rate | 30% |
For that, firstly a comparable company needs to be found out. Let’s suppose the comparable company X is in the same industry and has the following capital structure:
| Calculated Beta | 1.2 |
| Total Debt | $5 million |
| Total Equity | $10 million |
| Debt to Equity Ratio | 50% |
| Tax Rate | 35% |
The second step is to calculate the beta of the comparable company X. In this case, the beta is calculated and given as 1.2. The next step is to unlever the beta of company X using the above-mentioned formula.
Unlevered Beta of company X = Levered Beta of company X/ [1+ {1-Tax Rate}*D/E]
=1.2/[1+{1-0.35}0.5] =0.91
The Last step is to find out the levered beta of the company A. Since, both the company A and company X are in the same industry and are comparable, their unlevered beta will also be the same. The levered beta can be found using the formula:
Levered Beta of company A = Unlevered Beta of company A * [1 + {(1- Tax Rate) *(D/E)}]
= 0.91 * [1+ { (1-0.3)*0.4}] = 1.165