Unlevering Beta

In the fourth chapter of this module, we briefly touched upon the concept of beta. In this one, we’re going to go a little deeper and take a look at another concept that’s closely related to it - unlevered beta. In addition to taking a look at what unlevered beta is, we’re also going to be taking a look at the formula that is used to calculate the same, and a few other key things that you should know. So, let’s begin.

What is unlevered beta?

Before we get into the specifics, let’s quickly revisit the concept of beta. Beta or beta coefficient is a metric that measures the volatility of an asset compared to the volatility of the market as a whole. The higher the beta of a stock, the more volatile it is compared to the market.

Generally, when traders calculate the beta of an asset, they take both the debt and equity components of the asset’s capital structure to do so. The beta that’s calculated using both these components of the capital structure is also referred to as levered beta. This is primarily due to the fact that it takes leverage (debt) into account.

Unlevered beta, on the other hand, doesn’t take the debt component of an asset’s capital structure. And since it doesn’t use leverage (debt), it is commonly referred to as unlevered beta.

How is unlevered beta useful?

While levered beta is useful in itself to calculate the volatility of an asset compared to that of the market, it tends to skew the results when comparing the beta coefficient of two assets. Why? Because both the assets may not always have the same capital structure and debt levels.

For instance, let’s say that you’re trying to compare the beta coefficients (levered beta) of two companies. Company A has a higher debt component compared to Company B. Now, due to this, Company A may look like it is riskier than Company B, despite the fact that Company A has more than enough cash reserves to meet its debt obligations.

This is precisely why investors and financial experts use unlevered beta. By eliminating the debt component from the beta coefficient calculations, they can effectively nullify any discrepancies that may exist between the two companies, thereby leading to a more accurate and thorough comparison. However, since unlevered beta removes the debt component in a company’s capital structure altogether, the values here are almost always lower than levered beta.

How to calculate unlevered beta?

Calculating unlevered beta is extremely easy. That said, it requires you to know what the levered beta for the asset is. Once you know the value of levered beta, all that you need to do is apply the following unlevered beta formula.

Unlevered beta = Levered beta ÷ [1 + (1 - tax rate) x (debt ÷ equity)]

Let’s take a look at an example.

Assume that you’re trying to calculate the unlevered beta of a company. Here are the following assumptions that we’re going to make.

• The levered beta of the company is 1.05
• The tax rate is set at 20%
• The debt-equity ratio of the company is 0.55

Applying these assumptions in the unlevered beta formula, we get -

Unlevered beta = 1.05 ÷ [1 + (1 - 0.20) x (0.55)]

Unlevered beta = 0.73

As you can see from the above calculation, the unlevered beta is lower than the levered beta as we removed the effects of the debt component. Now, you could do the same to a comparable company to arrive at its unlevered beta and then compare the unlevered betas for both the companies.

What does the unlevered beta tell you about a company?

The unlevered beta of a company gives you some deep insights into the performance of its stock, relative to the market. For instance, if the unlevered beta of a company is positive, such as the one in the example above, investing in its stock during a bull market may be the right way to go. On the other hand, if the unlevered beta of a company is negative, you would do better investing in it during bear markets.

Wrapping up 

That’s about it for this chapter on unlevered beta. In the upcoming chapter, we’re going to be taking a look at the risk pyramid. So, stay tuned!   

A quick recap

• Beta or beta coefficient is a metric that measures the volatility of an asset compared to the volatility of the market as a whole. 
• A beta coefficient that’s calculated using both debt and equity components of a company is referred to as levered beta. 
• Unlevered beta doesn’t take the debt component of an asset’s capital structure and uses only equity. 
• Levered beta tends to skew the results when comparing the beta coefficient of two companies due to the difference in debt structuring. 
• Unlevered beta gives you a much more accurate comparison between two companies since debt is effectively eliminated. 
• Unlevered beta can be calculated using the following formula.
  Unlevered beta = Levered beta ÷ [1 + (1 - tax rate) x (debt ÷ equity)]
• Unlevered beta is almost always lower than the levered beta due to the elimination of the debt component.