Unlevered beta is a way to measure how risky a company is. It does not include the effect of debt. It shows how much the company’s stock owners add to its risk. This demonstrates how the products of the firm respond to the market.
Why Unlevered Beta Is Important
Beta is a common way to measure risk and return. It compares a stock to a market index, such as the S&P 500. A beta of 1 means that the stock moves like the market. A beta greater than 1 means that the stock is riskier than the market. The stock is less hazardous than the market if the beta is less than 1.
But beta can change because of the debt that a company has. Debt makes a company riskier, as it has to pay the money back no matter what. Debt also makes the returns to stock owners bigger or smaller. So, a company with high debt may have a high beta, but not because of its business risk.
To find the risk only from the company’s things, we can use unlevered beta. Unlevered beta takes out the effect of debt from levered beta. It uses the debt-to-equity ratio and the tax rate. By comparing the unlevered betas of different companies, we can see their risk better without being affected by their debt choices.
How to Find Unlevered Beta
Unlevered beta can be found from levered beta using this formula:
\text {Unlevered beta} =\frac { \text {Levered beta} } {\left ( 1 + \frac {\left ( 1-\text {tax rate} \right )*\text {Debt}} {\text {Equity}} \right )}
Levered beta is the normal beta that we can get from websites or by using math. The tax rate is the tax that the company pays on its income. Debt and equity are the values of the total debt and total equity of the company.
For example, suppose Company A has a levered beta of 1.2, a tax rate of 25%, a total debt of $100 million, and a total equity of $200 million. We can find its unlevered beta like this:
\text {Unlevered beta} =\frac { 1.2 } {\left ( 1 + \frac {\left ( 1-0.25 \right )*100} {200} \right )} = 0.857
This means that Company A’s things are less risky than the market, and its high levered beta is partly because of its high debt level.
Problems with Unlevered Beta
Unlevered beta is a good way to compare companies with different debt levels, but it also has some problems. Some of them are:
- Unlevered beta thinks that debt has no effect on the business risk of the company, which may not be true. For example, if a company has too much debt, it may go broke or have trouble paying back, which could affect its work and money.
- Unlevered beta uses old data and may not show the current or future risk of the company or the market. Also, unlevered beta may change depending on how long and how often we use it for finding levered beta.
- Unlevered beta does not include other things that may affect the risk and return of a stock, such as growth chances, strong points, industry changes, etc.
So, unlevered beta should be used carefully and with other ways of finding value and risk.
