Understanding Unlevered Beta: Definition, Formula, Sample, and Computation

What Is Unlevered Beta?

Beta serves as a gauge of market risk. Unlevered beta, also known as asset beta, evaluates a company’s market risk independent of its debt impact.

By ‘unlevering’ beta, the financial ramifications of leverage are excluded, thereby isolating the risk attributed solely to a company’s assets. Essentially, it quantifies the contribution of a company’s equity to its risk profile.

Key Takeaways

• Levered beta, often referred to as equity beta, factors in both debt and equity when assessing a company’s risk.
• Unlevered beta focuses on the pure risk associated with company assets by removing the debt component.
• A higher debt-to-equity ratio typically indicates increased risk regarding a company’s stock.
• A beta of 1 signifies equivalent risk to the market, with betas above or below 1 indicating higher or lower risk levels compared to the market.

Investopedia / Laura Porter

Understanding Unlevered Beta

Beta represents the slope of the coefficient for a stock regressed against a benchmark market index such as the S&P 500. Leverage, reflecting a company’s debt-to-equity ratio, plays a crucial role in determining beta. Levered beta assesses a firm’s risk considering its debt and equity, while unlevered beta removes any effects from debt, providing investors insight into the precise asset-related risk when buying a stock.

‘Unlevering’ beta entails eliminating the advantages or disadvantages gained through adding debt to a company’s capital structure. Comparing companies based on unlevered betas offers investors clarity regarding the risk composition associated with purchasing their stocks.

Take a company that increases its debt, elevating its debt-to-equity ratio. This action results in a higher proportion of earnings allocated to debt servicing, heightening investor uncertainty about future earnings streams. Consequently, the company’s stock is perceived as riskier, unrelated to market risks.

Isolating and excluding the debt component from overall risk leads to unlevered beta.

A company’s debt level can impact its performance, making it more responsive to fluctuations in its stock price. Despite a company having debt in its financial reports, unlevered beta disregards this debt, assuming a debt-free scenario in the calculation. Given varying capital structures and debt levels among companies, analysts can compute unlevered beta to effectively compare them against each other or the market, focusing solely on the sensitivity of a firm’s assets (equity) to the market.

To ‘unlever’ beta, one must know the company’s levered beta along with its debt-equity ratio and corporate tax rate.

Systematic Risk and Beta

Systematic risk results from external uncontrollable factors impacting a company. Examples include natural disasters, political events, inflation, and wars. Beta quantifies the systematic risk or volatility of a stock or portfolio.

Beta, a statistical metric, compares a stock’s price volatility with that of the broader market. Higher volatility, indicated by beta, implies higher risk, while lower volatility suggests lower risk.

A beta of 1 mirrors the market risk, with a beta of over 1 indicating higher volatility than the market, and less than 1 signaling reduced market volatility.

Example of Unlevered Beta

For instance, calculating the unlevered beta for Tesla, Inc. (as of November 2017):

• The beta (BL) is 0.73.
• The Debt to Equity (D/E) ratio stands at 2.2.
• The corporate tax rate is 35%.

Thus, Tesla’s unlevered beta is calculated 0.30.

Unlevered beta typically equals or falls below levered beta since debt is typically positive or zero. In rare cases where a company’s debt element is negative, like hoarding cash, unlevered beta might surpass levered beta.

A positive unlevered beta prompts investments in anticipation of rising stock prices, while a negative one encourages investments when prices are expected to drop.

How Can Unlevered Beta Help an Investor?

Unlevered beta eliminates the impacts of debt on a firm’s capital structure. By comparing companies’ unlevered betas, investors gain insights into the risk structure of stocks they are considering. Assessing unlevered beta allows for effective comparisons of companies’ asset sensitivities against each other and the market.

What Is Beta?

Beta (ß) evaluates market risk by measuring the volatility or systematic risk of a security or portfolio against the overall market. Essentially, it denotes the slope of the coefficient for a security regressed against a benchmark market index like the S&P 500. Each data point denotes an individual stock’s returns relative to the market, succinctly describing the response of a security’s returns in relation to market fluctuations.

What Is Levered Beta?

Levered beta gauges a company’s risk considering both debt and equity within its capital structure concerning market volatility. Leverage, representing a company’s debt-to-equity ratio, significantly influences beta. A levered beta exceeding 1 or falling below -1 reflects higher volatility than the market, while a beta between -1 and 1 indicates lower volatility compared to the market.