Adjusted Beta and Equity Beta
When evaluating investments in financial markets, it is important to assess the risk of a particular investment. One commonly used metric to measure the risk of an investment is beta. Beta, also known as systematic risk, measures the volatility of an investment in relation to the overall market.
What is Beta?
Beta is a measure of the sensitivity of an investment’s returns to changes in the overall market. It is calculated by comparing the investment’s returns to the returns of a benchmark index, such as the S&P 500. The beta of the benchmark index is set to 1.0, and investments with a beta greater than 1.0 are considered more volatile than the market, while investments with a beta less than 1.0 are considered less volatile than the market.
For example, if a stock has a beta of 1.5, it is expected to move 50% more than the market in either direction. If the market moves up by 10%, the stock is expected to move up by 15%. Similarly, if the market moves down by 10%, the stock is expected to move down by 15%.
What is Adjusted Beta?
Adjusted beta, also known as levered beta or beta with debt, is a modified version of beta that takes into account the impact of a company’s debt on its risk profile. The basic idea is that the beta of a company can be influenced by the amount of debt it has in its capital structure. Therefore, adjusting beta to reflect the impact of debt can provide a more accurate measure of a company’s risk.
To calculate adjusted beta, the unlevered beta of the company is first estimated. The unlevered beta represents the risk of the company’s underlying assets without the effects of debt. The unlevered beta is then levered up to reflect the effects of debt on the company’s stock returns using a formula that considers the amount of debt and the tax rate.
Adjusted Beta = Unlevered Beta x [1 + (1 – Tax Rate) x (Debt / Equity)]
By accounting for the effects of debt on a company’s stock returns, adjusted beta provides a more accurate measure of a company’s systematic risk.
What is Equity Beta?
Equity beta is another version of beta that focuses only on the risk of a company’s equity. It measures the volatility of a company’s stock price in relation to the overall market, without accounting for the effects of debt. Equity beta is commonly used to calculate the cost of equity capital, which is the return that investors require on their investment in the company’s stock.
To calculate equity beta, the returns of a company’s stock are regressed against the returns of a benchmark index, such as the S&P 500. The slope of the regression line represents the equity beta.
The use of equity beta instead of adjusted beta depends on the specific analysis being conducted. For example, if the focus is on evaluating the risk of the company’s equity, then equity beta may be a more appropriate measure. However, if the focus is on the overall risk of the company, adjusted beta may be more appropriate.
