Unlevered beta is a measure of a firm's risk after removing the effects of the company’s debt. This represents the beta a firm would have if it had no debt and only obtained financing through equity.
This article will explain unlevered beta in detail, including a description of beta and how it is used, the difference between levered and unlevered beta, and how to calculate unlevered beta.
What Is Beta?
To understand unlevered betas, you first need to understand the basics of beta in general.
To calculate beta, you start by dividing the standard deviation of the return on an investment by the standard deviation of the return on the market. Next, multiply your answer by the correlation coefficient between the return on the stock and on the market. Beta can also be calculated using regression analysis.
The value of beta tells you the relationship between the returns on an investment and the returns on the market.
- When beta is exactly equal to 1, then the asset is expected to move in precisely with the market.
- When beta is greater than 1, then the security is expected to be even more volatile than the market in general.
- When beta is less than 1, the security is expected to be less volatile than the market.
Often, the S&P 500 index is used to represent the market when calculating beta.
Stocks with higher betas are expected to provide higher returns during periods when the market as a whole is rising. A higher-beta stock is also expected to produce even worse returns than the market when the overall market is declining.
Beta is one of the primary values in the Capital Asset Pricing Model (CAPM), which is commonly used to assess risk as well as determine the cost of equity capital for business firms.
How Does Unlevered Beta Work?
In most cases, when you see the use of beta or read about it in a textbook or journal, the standard beta is used. This version of beta can be thought of as “levered” because it includes the effect of the company’s use of debt, or leverage.
By including debt, beta measures the effects of both the business risk and financial risk of a firm at its current level of debt. Unlevered beta, by removing the effect of the company’s current debt level, measures only the firm's basic business risk, irrespective of financing.
A company can have different capital structures that would each affect beta differently, and it may be helpful to assess the effect of the firm's business risk without including debt. A firm may also want to know what its cost of equity would be at different levels of debt. Unlevered beta can be helpful in these situations.
How To Calculate Unlevered Beta
To calculate unlevered beta, you first need to calculate the standard or normal beta, as described earlier. You can then modify this value to find unlever beta.
The formula for unlevered beta is:
Unlevered Beta = Beta / (1 + (1-Tax Rate) (Debt/Equity))
The last segment in the formula is the debt-to-equity ratio, which shows how the standard beta is adjusted for the amount of debt the firm has.
As an example of unlevered beta, let’s assume you have a firm with a beta of 1.7 and a debt-to-equity ratio of 0.4. You can use a corporate tax rate of 21%.
This firm's unlevered beta would be:
1.7 / (1 + (1-0.21)(0.4)) = 1.29
As you can see, removing the effect of the firm's debt lowered the beta. This is theoretically and logically sound because debt is a source of risk. Because beta measures risk, removing the debt should lower beta.
- Beta is a measure of a firm's risk relative to the market. It is also a key component of the Capital Asset Pricing Model, which is often used to estimate a firm's cost of equity financing.
- Beta includes the effects of both a firm’s business and financial risk.
- Unlevered beta does not include the firm's debt. Normally, beta is calculated with the effect of the firm's debt included.
- Unlevered beta can be found by modifying a firm’s regular beta.