Session 5: Betas (Relative Risk Measures)

Summary

This video script explores the process of estimating the expected return for investments, specifically focusing on measuring relative risk through beta. It highlights the limitations of regression-based beta estimates and introduces the concept of 'bottom-up' betas, which consider a company's business structure, cost composition, and debt levels. The speaker emphasizes the importance of understanding a company's risk profile and offers alternatives to regression betas, such as sector averages and accounting measures, to ensure a more precise and meaningful assessment of risk. The goal is to apply the appropriate discount rate to companies with varying risk levels.

Takeaways

• 😀 Beta is a measure of relative risk used to estimate how risky a stock is compared to the average market stock.
• 😀 The CAPM beta model relies on regression analysis, where stock returns are regressed against market returns to determine beta.
• 😀 Regression betas can be noisy and unreliable due to factors such as the time period used, the frequency of returns, and market characteristics.
• 😀 The standard error of a beta estimate is crucial, and typical errors can range around 0.2, meaning the true beta might vary significantly from the regression result.
• 😀 A good-looking regression doesn’t guarantee a good estimate of beta, especially when data or market conditions skew the results.
• 😀 Bottom-up betas, derived from industry averages, offer a more reliable method for measuring risk, particularly when a company has multiple business sectors.
• 😀 To calculate a bottom-up beta, you first gather the betas of comparable companies in the same industries, adjust for their debt levels, and then average them.
• 😀 Bottom-up betas are more precise than regression betas because they average out errors from multiple sources and can better capture sector-specific risks.
• 😀 Using bottom-up betas also allows you to account for companies with multiple business lines or plan for future business expansions.
• 😀 A bottom-up beta is not limited to public companies; it can also be used for private businesses by estimating industry betas and adjusting for leverage.
• 😀 The final beta for a company should take into account not only its industry and debt but also the specific risks associated with its business activities.

Q & A

What are the primary ingredients for estimating the expected return of an average-risk investment?

The primary ingredients for estimating the expected return of an average-risk investment are the risk-free rate and the equity risk premium.

Why is it important to measure relative risk when evaluating an investment?

Measuring relative risk is crucial because it helps assess how risky a particular investment is compared to the market or an average-risk investment, ensuring an accurate cost of equity for non-average-risk companies.

What does beta represent in finance, and why is it essential?

Beta represents a company's relative risk in comparison to the market. It is essential because it helps determine the risk-adjusted return for an investment, especially when calculating the cost of equity.

What are the limitations of using regression-based betas for estimating risk?

Regression-based betas have limitations, including variability due to the period, index used, and type of returns. Additionally, they can be noisy, and the coefficient obtained can be inaccurate, as shown by the standard error.

What is the 'bottom-up beta' approach, and why is it preferred over regression betas?

The 'bottom-up beta' approach involves calculating a company's beta by averaging the betas of comparable companies in the same sector, adjusting for debt. This method is preferred because it provides more precision and removes the noise found in regression-based estimates.

How does the type of business a company is in affect its beta?

The more discretionary a company's product or service (i.e., something customers can delay or do without), the higher its beta will typically be. Conversely, businesses providing essential goods or services (like grocery stores) tend to have lower betas.

What role does a company's cost structure play in determining its beta?

A company with a high proportion of fixed costs will have a higher beta because its profits are more volatile, with good times being great and bad times being much worse.

How does borrowing money affect a company's beta?

Borrowing money increases a company's fixed costs through interest expenses, which magnifies both good and bad times for equity investors. Therefore, more borrowing (higher debt) typically leads to a higher beta.

What are the advantages of using bottom-up betas over regression betas?

Bottom-up betas offer several advantages, including greater precision through averaging multiple betas, the ability to adjust for new or planned businesses, and the ability to estimate betas for private companies, which cannot be done using regression betas.

How can a bottom-up beta be calculated for a company with multiple businesses?

To calculate a bottom-up beta for a company with multiple businesses, you first estimate the betas for each business sector, adjust them for debt, and then use the revenue or value weights of each business to calculate a weighted average beta for the company as a whole.