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Understanding the risks associated with investments is one of the most crucial factors to consider before making an investment decision. Various tools help assess the risks of financial instruments. One such tool in the stock market is beta.
Beta can be of different types. Today’s article focuses exclusively on unlevered beta. Let’s understand what unlevered beta means and its significance in analysing the risks of stocks.
What is beta?
The market has two types of risks – systematic and unsystematic.
Unsystematic risk includes risk factors that are specific to a company or industry. Usually, investors can mitigate such risks by using different strategies like diversification. Systematic risk, on the other hand, includes risks that affect the market as a whole. For example, the stock market crashing during a recession or depression.
Investors cannot control systematic risk. However, the systematic risk associated with each stock can be analysed beforehand, so that investors can stay away from such stocks if the risk is beyond their tolerance.
One of the ways to calculate systematic risk is by using beta. A beta is a statistical tool that measures a stock’s systematic risk by comparing the stock’s volatility against a benchmark index’s volatility.
What is unlevered beta?
While calculating beta, the entire value of the company, including all its assets and debts, is considered.
Unlevered or unlevering beta involves removing the debt component while calculating a company’s beta. Simply put, unlevered beta is a tool that measures the rate of risk that a company’s assets are exposed to.
Understanding unlevered beta
Beta usually calculates a company’s exposure to market risks considering assets and debts. But, such value may not be accurate because the firm’s numbers include leverage. A company with leverage will require costs to service the debt, which will impact the investor’s earnings. However, such impact is not due to market risk. Hence, considering debts while calculating beta may not give the actual picture of the stock’s exposure to market risk.
To eliminate any positive or negative influence of debt on the beta value, unlevered beta ignores the aspect of debt entirely. It purely considers the impact on assets due to market risks.
Calculating unlevered beta
Unlevered beta formula:
Unlevered beta = Levered beta ÷ [1 + ((1 – Tax rate) x Debt to equity ratio)]
Unlevered beta is usually the same or less than the levered beta because removing the debt component reduces risk.
- Beta of 1: Stock’s risk = Market risk
- Beta > 1: Stock’s risk > Market risk
- Beta < 1: Stock’s risk < Market risk
Example of calculating unlevered beta:
Let’s consider the example of Reliance Industries, whose beta or levered beta (includes debt and equity) is 1.14. The firm’s debt-to-equity ratio is 0.41.
For the convenience of calculating unlevered beta in the example, let us assume a flat tax rate of 30%.
Unlevered beta = 1.14 ÷ [1 + ((1 – 0.3) x 0.41)]
Unlevered beta of Reliance Industries = 0.88
As you can see, unlevered beta is significantly lower than levered beta after excluding the debt component.
The significance of unlevered beta
Analysing the unlevered beta of a stock helps in making various judgments, from investing as a retail investor to making decisions like mergers and acquisitions.
Unlevered beta also helps investors do an apple-to-apple comparison of stocks. There may be similar firms from the same sector with identical market risks. However, due to a change in their debt-to-equity ratios, one firm may seem more riskier than the other. This does not give an accurate picture of stocks reacting to market risks since it is influenced by debt. Unlevered beta eliminates this issue by removing the debt factor.
Bottomline
Unlevered beta is a statistical tool that measures the systematic risk of a stock without considering the firm’s debts. Unlike levered beta, which considers both equity and debt, levered beta considers only assets while calculating a firm’s exposure to risks.
Considering debts increases the risk factor since it includes the cost of servicing and repaying debts. Hence, using unlevered beta helps investors assess the real risk of stocks to market events. It is an essential tool that aids major investment decisions.
FAQs
Levered and unlevered beta are two different ways of calculating a stock’s exposure to market risk.
Levered beta is where a company’s debts and assets are both considered while analysing its volatility to systematic risks. Unlevered beta excludes debts and only includes assets to analyse a stock’s exposure to market risks.
Knowing the difference between unlevered beta vs levered beta is essential for traders to assess a stock’s vulnerability.
Unlevered beta is better than levered beta as it excludes the debt component while calculating a stock’s risk to market uncertainties. Debt usually increases a stock’s risk, hence magnifying the value of beta. However, risks due to debts are not part of systematic risks, hence, it is ideal to remove them while calculating a stock’s pure volatility to market.
CAPM stands for Capital Asset Pricing Model. It is a tool to measure an investment’s risk and return.
Levered beta or beta, which includes both debt and equity, is considered while calculating CAPM. Since CAPM is used to assess the return an investor can earn from stocks, it is essential to include debts too, because a company’s debt ratio impacts the investor’s earnings.
No, debt does not affect market risk.
Debt affects a company’s overall risk, which includes both systematic and unsystematic risks. It is part of the unsystematic risk, which is controllable. However, a company’s debt is not part of market risk which is common for the entire market.
Yes, levered beta is usually higher than unlevered beta. This is because levered beta also consists of debt, which increases the overall risk factor. Since unlevered beta excludes debt, it is either equal to levered beta or lower than that.