"I'm actually wedded to bottom-up betas" — Aswath Damodaran
I have recently decided to devote more attention in class to what Prof. Damodaran calls 'bottom-up' betas. Students seem to find it interesting too. Here's some video material with the explanations:
1. Identify the business or businesses that make up the firm whose beta we are trying to estimate.
2. Calculate the levered betas of other publicly traded firms that are primarily or only in each of those businesses. Use regression analysis. In most businesses, there are at least a few comparable firms and in some businesses, there can be hundreds. Begin with a narrow definition of comparable firms, and widen it if the number of comparable firms is too small. Consider the possibilities of widening your search globally to get more firms in your sample. Do hundreds of regression! [TABLE]
3. Calculate the average of levered betas for each relevant sector.
4. Use the average debt-to-equity ratio (D/E) for each sector [this information will be provided] to ‘unlever’ the average beta with the formula: βU = βL / [ 1 + (1 – t) (D/E)]. This is the average unlevered beta for each division.
5. Calculate the bottom-up unlevered beta of the firm as a weighted-average of the unlevered betas for each division. But what weights do we use? There are two possibilities: use the proportion of the enterprise value of the businesses relative to the total enterprise value of the firm (enterprise value = market value of debt + market value of equity – cash). Or you could just use the revenues (sales) by sector.
6. Use the debt-to-equity ratio of the company to arrive at the levered beta, using the formula: βL = βU [ 1 + (1 – t) (D/E)]. That’s it!
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