Session 9: Estimating Hurdle Rates - Betas and Fundamentals

Summary

In this corporate finance class, the focus is on understanding betas and how fundamental business decisions influence them. The lecture critiques the use of regression betas, emphasizing their noisiness due to varying data choices. Instead, it suggests a more robust approach by analyzing a company's business type, cost structure, and leverage. The type of business—cyclical or non-cyclical—affects beta, as do fixed costs and the level of debt. Real-world examples like Disney, Microsoft, and ExxonMobil illustrate how these factors shape a company’s beta, ultimately showing that beta is driven by choices, not just regression models.

Takeaways

• 😀 Regression betas can be unreliable due to the noise and variations in inputs like the choice of index and historical data periods.
• 😀 A company's beta is influenced by its fundamental choices, including its type of business, cost structure, and leverage.
• 😀 Discretionary products, like luxury goods, tend to have higher betas because their demand is more volatile in response to economic conditions.
• 😀 Companies with high fixed costs, like telecom firms, face greater earnings volatility, leading to higher betas.
• 😀 Diversified companies, like GE, tend to have lower betas due to the smoothing effect of their multiple business operations.
• 😀 Even businesses with seemingly low-risk activities can have high betas if they are heavily leveraged (e.g., Disney's beta is affected by its debt ratio).
• 😀 Oil companies like ExxonMobil may have lower betas because their primary risk (oil price fluctuations) moves in the opposite direction of the market at times.
• 😀 Negative beta companies, like gold mining firms, act as a hedge against market downturns and are often considered insurance in a portfolio.
• 😀 Addiction-based businesses, such as Philip Morris, exhibit lower betas because their revenues are more stable regardless of economic cycles.
• 😀 To assess a company's operating leverage, the percentage change in operating income compared to revenue change can give insights into its fixed cost structure.
• 😀 When a company increases its debt, its equity beta (levered beta) increases, showing higher market risk and cost of equity, especially in leveraged buyouts.

Q & A

What is the main focus of the session discussed in the script?

The main focus of the session is to explore better ways of estimating betas, particularly by examining the fundamental decisions a company makes that can affect its beta, such as the type of business it is in, how it runs that business, and how much it borrows to fund it.

Why does the speaker express skepticism about using regression betas?

The speaker is skeptical about using regression betas because they are noisy and based on one slice of history, leading to uncertainty. The regression estimates can vary depending on the chosen index and can be influenced by statistical errors.

How can the choice of index affect the regression beta?

The choice of index can lead to very different beta estimates. For instance, using different benchmarks, like local equity indices or global indices, can result in varying betas, making the regression results unreliable.

What is the significance of the regression beta range mentioned for Tata Motors?

For Tata Motors, the regression beta is 1.83, but the range can vary between 1.5 and 2.2 due to the standard error of the beta estimate. This wide range highlights the uncertainty in relying on a regression beta for accurate risk assessment.

What are the three fundamental factors that determine a company’s beta according to the script?

The three fundamental factors are: (1) the type of business the company is in, (2) the company’s cost structure (particularly the proportion of fixed costs), and (3) how much the company borrows (its leverage).

Why do luxury product companies have higher betas?

Luxury product companies, such as Bulgari, have higher betas because their products are discretionary, meaning their sales are more volatile: they perform well in good economic times but suffer significant declines in bad times, causing more fluctuation in their stock price.

What role does fixed cost structure play in determining beta?

Companies with a high proportion of fixed costs tend to have higher betas because their profits are more sensitive to changes in revenue. In good times, their profits increase significantly, but in bad times, they suffer large declines, magnifying the volatility of their stock price.

Why does ExxonMobil have a relatively low beta despite exposure to oil price risk?

ExxonMobil has a relatively low beta because the risk associated with oil prices often moves in the opposite direction of the broader market, meaning that when the market suffers, ExxonMobil may not be as negatively affected, leading to a lower overall beta.

What does a negative beta, as seen in Harmony Gold Mines, indicate?

A negative beta, such as that seen in Harmony Gold Mines, indicates that the company acts as a hedge against broader market risks. In this case, the gold mining business can serve as a protection against inflation and other financial asset risks, often resulting in returns below the risk-free rate.

How does a company’s borrowing (leverage) affect its beta?

When a company borrows money, it increases its fixed costs, making its equity earnings more volatile. This increases its levered beta, meaning that companies with higher debt-to-equity ratios will have higher betas due to the added financial risk.