Unlevered Beta: Meaning, Examples and Calculations
Risk is an integral part of an investment; every opportunity of earning money comes with certain risks. Investors use several technical analysis tools to measure risks which helps them in making meaningful strategic decisions. A beta is a tool that measures the market risk associated with a company. An unlevered beta is a modified version of beta where you can measure market risks after removing the effects of financial leverage.
Read on to understand what unlevered beta is, how it works, formula and calculation, this concept and its uses.
What is Unlevered Beta?
As the name suggests, it is an unlevered form of beta. However, many experts also refer to it as asset beta because it measures market risks related to the company without factoring in the impact of debt.
It will only give a measure of risk with regard to the company’s assets or risk contributed by equity instruments of the company. This is a popular tool used by investors when dealing with unlisted firms because it is difficult to get hold of the debt information of an unlisted company.
Now that you know the meaning of unlevered beta, let’s shift our focus to its other aspects like working and calculation.
How Does Unlevered Beta Work?
You can compute beta by considering the trajectory of the stock with respect to benchmark indices popularly known as Sensex or Nifty. It gives due importance to financial leverage, which is measured by the debt to equity ratio of the company.
On the other hand, an unlevered beta is a modified version of the beta, and it measures market risk without considering the effects of financial leverage. It primarily negates the positive as well as the negative impact of debt while computing market risks. It helps you to analyse the risks faced by a company or an investment from the asset side.
What is the Formula for Unlevered Beta?
The unlevered beta formula is as follows:
Unlevered beta = Levered Beta / [{1+ (1- Tax Rate)}*Debt/Equity]
Here, levered beta means measuring market risk after considering the impact of financial leverage.
How to Calculate Unlevered Beta?
In order to determine an unlevered beta, you need to remove the impact of debt from beta.
First, you need to collate the values of beta from a group of companies in the same industry. Next, you need to unlever each one of them. After that, compute the median value from this set, and again re-lever the same as per the capital structure of your company.
Thereafter you can use this in the formula of unlevered beta and get the requisite value.
What are Examples of Unlevered Beta?
Suppose company ABC Pvt Limited has the following fundamentals, which will help in the calculation of unlevered beta.
Levered beta = 2.4
Tax rate = 30%
Debt to equity ratio of the company = 0.75
Now, by using these values in the formula mentioned above, we get
Unlevered beta = Levered Beta / [{1+ (1- Tax Rate)}*Debt/Equity]
= 1.6/ (1+ {(1- 0.30)*0.75}
= 1.04
Therefore, you must make sure that you have all the relevant information available to you. Using this information, you can compute unlevered beta by merely placing them in the appropriate formula.
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What are the Uses of Unlevered Beta?
Here are some pointers that highlight the importance of unlevered beta:
• Helps in Comparison
It is an effective tool for comparing market risks of companies operating in the same sector with diverse capital structures. Deleveraging or removing the impact of debt can lead to an accurate comparison between the companies.
• Risk of Unlisted Companies
This tool uses the pure play method for computing market risk of unlisted companies. As debt information of unlisted companies is not easily accessible, this variable will help potential investors in gauging the risk prevalent in unlisted companies.
• Systematic Risk
You can get an idea regarding systematic risks prevalent in a company by using this unlevered beta. It shows risk arising from the equity or asset structure of the company and makes it easier to compare companies having diverse capital structures.
What is a Levered Beta?
Levered beta, also known as geared beta, considers both debt and equity structure of a company and measures the risk with regard to prevailing volatility in the market. In case of levered beta, debt associated with the company can significantly influence the market risks.
The higher the debt, the more amount will be required by companies to pay off their debts. It pushes up the risk quotient of the company.
What is the Difference Between Levered and Unlevered Beta?
As the name suggests, a levered beta considers financial leverage or the impact of debts while computing risks in relation to overall market volatility.
On the other hand, an unlevered beta deleverages or removes debt from the company’s fundamentals before computing market risks of the company.
Levered beta does not provide information regarding the systematic risks of a stock or company. However, an unlevered beta gives an idea about the systematic risks prevalent in a stock or company.
Final Word
Unlevered beta is an effective measure of computing market risks. However, it does not factor in the debt variable while computing risks with regard to overall market volatility. Since firms must pay interest on outstanding debt, un-levering removes that consideration from analysis.
FAQs
Ans: Systematic risks are not company specific and are inherent to overall public equities. On the other hand, unsystematic risks are company specific and can be rationalised with proper portfolio management.
Ans: A levered beta is an effective measure to ascertain the sensitivity of a particular security with respect to the overall market volatility. You will be able to know the risk level in that security and its future tendency considering market situation.
Ans: Unlevered beta does not consider the debt component while computing risk. Therefore, a higher value of unlevered beta means higher risk associated with the company’s equity and may not be a positive sign for investors.
Ans: Yes, we need to unlever the value of beta for every comparable company before we start to compute CAPM. The calculation of cost of equity requires an accurate beta value, but before using this value, we have to unlever or remove the debt component.
