Beta Estimation for Public Companies, thinly traded Companies, and Nonpublic Companies

Beta is an estimate of a company’s systematic or market-related risk.

Estimating Beta for Public Companies

For public companies, beta is estimated through ordinary least squares (OLS) regression of returns on a stock on the returns on the market. The following factors influence the beta estimates from such a regression:

• The choice of index used to represent the market portfolio. For example, the S&P 500 index is used as the market portfolio for the US equities.
• The length of the data period and the frequency of observations. The most common choice is five years of monthly data, yielding 60 observations.

The beta value obtained through OLS regression is known as raw or unadjusted historical beta. Betas have tended to revert toward 1.0 over time, and since valuation is forward-looking, raw betas are adjusted so that they more accurately reflect future betas.

$$
\text { Adjusted beta }=\left(\frac{2}{3}\right)(\text { Unadjusted beta })+\left(\frac{1}{3}\right)(1.0)
$$

Estimating Beta for Thinly Traded and Nonpublic Companies

Analysts can indirectly estimate the beta of nonpublic companies using the beta of publicly traded comparable companies. This procedure must consider the effect on the beta of differences in financial leverage between the nonpublic company and the comparable one. This is done in two steps:

Step 1: The comparable company’s beta is unlevered to reflect the systematic risk. This is known as asset beta (β_U).

$$
\beta_{U}=\left[\frac{1}{1+\frac{D}{E}}\right] \beta_{E}
$$

D and E represent the nonpublic company’s debt and equity levels in this case.

Step 2: The unlevered beta (asset beta) is then re-levered to reflect the financial leverage of the comparable company.

$$
\beta_{E}=\left[1+\frac{D}{E}\right] \beta_{U}
$$

Analysts may use the median or average industry beta rather than a comparable company’s beta. The un-levering and re-levering process can be applied to the asset beta using the median or average industry capital structure.

Question

Which of the following processes is most likely to be applied to an asset beta to reflect the effect of financial leverage when estimating the beta of a nonpublic company?

1. Adjusted beta.
2. Re-levering.
3. Unlevering

Solution

The correct answer is B.

Re-levering is the process of incorporating the effect of the subject company’s financial leverage on an asset beta.

A is incorrect. Adjusted beta is the estimated beta that reflects the tendency of betas to revert to 1.0 over time.

C is incorrect. Unlevering is the process of eliminating the comparable company’s financial leverage from its beta so that it only reflects the systematic risk. This process is used to arrive at the asset beta.