Beta: Major input in Discounted Cash Flow Valuation
Introduction
When it comes to valuing a company, one of the most widely used methods is the discounted cash flow (DCF) analysis. This method involves estimating the present value of a company's future cash flows, which requires several key inputs such as the discount rate and the growth rate. Another important input in the DCF calculation is Beta, which measures a stock's volatility relative to the overall market.
Beta is a crucial factor in determining the cost of equity, which is a key component of the discount rate used in the DCF analysis. In this blog, we will delve deeper into the concept of Beta and its role as a major input in the DCF calculation. We will also explore how Beta is calculated, its relationship with risk and return, and some practical considerations when using Beta in business valuation.
Before discussing further how Beta calculation is done, we need to first understand why and where it is implemented.
Cost of Equity
Cost of equity in corporate finance and valuation refers to the total return that a company is required to make to meet the capital return requirement from that particular investment. A company’s cost of equity reflects upon the compensation that an investor demands in exchange of the risk that the investor is taking for putting in their hard-earned money in an investment. The formula for cost of equity is as follows:
Ke = Risk-Free Rate of Return + Beta × ( Market Rate of Return - Risk-Free Rate of Return )
Since Cost of equity is required in a DCF valuation to discount the projected cashflows, a good estimation of Beta is required to perform a reliable valuation.
What is Beta
In Beta in business valuation refers to the quantifiable risk and the volatility associated with an investment relative to the overall market. When you look at Beta of a company you get a good idea of the risk associated with investing in the company. It represents the sensitivity of the investment to the change in the market. It can also be called as a reactivity indicator of risk with respect to the market movements
A Beta of 1 indicates that the investment in question will move in line with the market. So, if the market shows an increase of 10 % then the, then the investment goes up by approximately 10 %. Similarly, if the market experiences a phase of high volatility and risk, the investment will also show approximately similar volatility and risk.
Now if the Beta is greater than 1 will indicate that the investment is more volatile than the markets. So, if the market goes up, let’s say by 20%, the investment in question would go up by more than 20% and vice versa if the market goes down.
Similarly, a Beta of less than 1 will indicate that the investment is less volatile relative to the market volatility. If the market goes up by 15%, then then investment would go up by less than 15%.
There can be a scenario where the Beta of an investment may turn negative. This means that the investment’s movement relative to that of the market is opposite. This is a rare occurrence, but it can occur in certain industries such as gold and utilities.
For easier explanation we will take example of a company for which we need to calculate the Beta. To calculate the Beta for a company, follow the steps given below:
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Obtain the weekly price of the stock
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Obtain the weekly price of the market Index (Nifty, Sensex)
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Calculate the weekly change in price for the stock.
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Calculate the weekly change in the index.
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To calculate the Beta, use the Slope Function or the Covariance Function for both the resultant weekly return series.
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The resulting value is the Beta of the target company.
Two most commonly used approaches to Beta calculation:
?The slope function represents a regression analysis of the two-resulting series.
The covariance function measures the degree to which two variables move together. The covariance function is the most commonly used approach in business valuation.
In a more practical implementation of the Beta calculation, such as in a DCF calculation, we might want to use daily return instead of weekly return to provide us with a more reliable value of Beta. Also, the data that we will consider for calculation would span according to the growth phase in which the target company is operating, questioning whether the company is a Young Growth company with high growth rates, an Establish Growth company with diminishing positive returns or a mature company with a more or less stable returns. Mature Companies usually have a Beta pretty close to 1 since they move almost similarly to the market.
In case of a privately held company this approach may require a little more adjusting. We can calculate the Beta using the comparable peers of the target company that are publicly traded. To calculate a usable Beta value, an average of the Beta values of comparable companies can be considered. Another good substitute of the Beta value of a private company can be the Industry Beta of that particular industry.
After the Beta calculation is accurately done, we can then use the Beta value in our cost of equity calculation to factor in the risk and volatility of the market. Further, we discount the projected cashflows to arrive at the fair value of the target company.
Concluding thoughts
In conclusion, Beta is a significant input in DCF valuation. The importance of Beta can clearly be seen in its ability to provide insights into the reactivity and volatility of the investment in question with respect to the market risk and volatility. Beta when implemented in the discounted cash flow model would help us give an adjusted value of the target company for its reactivity to general change in the market returns.
Thus, it can be considered as one of the most important inputs that are used in DCF valuation and computation of which becomes critical given the weightage of Beta in calculating the discount rate in a valuation context.