A company’s beta is a measure of the volatility, or systematic risk, of a security, as it compares to the broader market. The beta of a company measures how the company’s equity market value changes with changes in the overall market. It is used in the capital asset pricing model (CAPM) to estimate the return of an asset.
Investors use different methods for calculating the beta of a public company versus a private company. In this article, we discuss the different approaches you can use to calculate a company’s beta.
Beta as an Indicator
Beta, specifically, is the slope coefficient obtained through regression analysis of the stock return against the market return. You can use the following regression equation to estimate the beta of the company:
ΔSi=α+βi×ΔM+e
where: ΔSi=change in price of stock i
α=intercept value of the regression
βi=beta of the i stock return
ΔM=change in the market price
e=residual error term
Calculating Beta From Comparable Public Companies
In this approach, we first need to find the average beta of the publicly traded companies that generate income from similar operations as the private company. This will be a proxy for the industry average levered beta. Second, we need to unlever the average beta using the average debt-to-equity (D/E) ratio for these comparable companies. The final step is to re-lever beta, using the private company’s target debt-to-equity ratio.
Earnings Beta Approach
Usually, listed companies are large companies that operate in more than one segment. Therefore, it may be problematic to find a comparable firm whose beta would adequately represent the business beta of the private company being valued. For instance, Apple Inc. (AAPL) has a diverse set of operations, including personal computers, smartphones, tablets, and other items. This company would likely be poorly comparable to a private company that has a single operation, such as smartphone production.
When it is difficult to obtain reliable comparable beta, a company’s earnings beta can be used as a proxy for the levered beta. In this method, the company’s historical earnings changes are regressed against the market returns. An appropriate market index can be used as a proxy for the market. For instance, if the company is operating in the U.S. market, the S&P 500 can be used as a proxy.
The Bottom Line
The valuation of private companies using CAPM can be problematic because there is no straightforward method for estimating equity beta. To estimate the beta of a private company, there are two primary approaches.
One approach is to obtain a comparable levered beta from an industry average or from a comparable company (or companies) that best mimics the current business of the private company, unlever this beta, and then find the levered beta for the private company using the company’s target debt-to-equity ratio. Alternatively, one can find the beta of the company’s earnings and use it as a proxy for the company after appropriate adjustments are made.