Uday Damodaran

XLRI Jamshedpur

Session 18
Beta: Fundamental Drivers;
Leverage, Asset Beta and Equity Beta

GMP 14-15: Financial Management

Session 18

Uday Damodaran
XLRI Jamshedpur

Analyzing Risk, Going Deeper

Uday Damodaran
XLRI Jamshedpur

Beta, and Risk Premium

We said that desired rate of return is a function of risk and

that an index of the relevant risk (systematic risk) is beta.
And how did we go around measuring it?

Uday Damodaran
XLRI Jamshedpur

Beta

How did we go around measuring it?

What about the beta for hundreds of businesses whose
stocks are not listed?
Take betas of similar companies?
Instead let us try and look at the concept of risk (and beta)
in a non-numerical, analytical manner

Uday Damodaran
XLRI Jamshedpur

Aswath Damodaran

There are three approaches available for estimating these

parameters. The first is to use historical data on market prices
for individual investments. The second is to estimate the
betas from the fundamental characteristics of the investment.
The third is to use accounting data.

Uday Damodaran
XLRI Jamshedpur

Risk Analytics

Let us look at firm risk in a more analytical way

Which, according to you, are the most risky sectors,
companies?
What are the major sources of risk?

Uday Damodaran
XLRI Jamshedpur

Risk: Sensitivity of Sales to Changes in the Economy

E
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TOP

LINE

Uday Damodaran
XLRI Jamshedpur

Risk: 2. Matter of Design

E
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TOP

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EBIT

Uday Damodaran
XLRI Jamshedpur

Degree of Operating Leverage

Firm 1

Firm 2 Firm 1

Firm 2

Firm 1

Firm 2

Base

Base

( I)

(I)

(II)

(II)

100

100

200

200

50

50

VAR. COST

80

40

160

80

40

20

FIXED COST

10

50

10

50

10

50

EBIT

10

10

30

70

-20

SALES

CASE (I): 100% increase in sales

CASE (II): 50% decrease in sales

Uday Damodaran
XLRI Jamshedpur

Which industries might be the..

Diciest?
Sir Richard Charles Nicholas Branson, and..
A recession is when you have to tighten your belt;
depression is when you have no belt to tighten. When you
have lost your trousers, youre in the airline business
Sir Adam Thomson, founder and chairman of British
Caledonian Airlines

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Uday Damodaran
XLRI Jamshedpur

DOL

What does DOL measure?

Sensitivity of EBIT to changes in Q
And what does it depend on?
The Operating Cost Structure and the level of output (Q)
Therefore, if you wish to lower DOL, how will you do it?
Increase Q or change cost structure by converting fixed
costs into variable costs (outsource)

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Uday Damodaran
XLRI Jamshedpur

Business Risk

FIRM 1

DOL
Sales

3
Stable, Very
Predictable

FIRM 2

1.5
Volatile, Very
Unpredictable

For which firm is EBIT more volatile?

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Uday Damodaran
XLRI Jamshedpur

Business Risk

Therefore:
Business Risk (Variability in EBIT):
Function of DOL, Variability in Q + Noise

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Uday Damodaran
XLRI Jamshedpur

Risk: 2. Matter of Choice

E
c
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Variability in Q

TOP

LINE

DOL

EBIT

+ Noise!!

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Uday Damodaran
XLRI Jamshedpur

Connecting things

EBIT

Function of
cyclicality, DOL
Function of
Q, Cost
Structure

15

Uday Damodaran
XLRI Jamshedpur

Business Risk

Therefore:
Business Risk (Variability in EBIT):
Function of DOL, Variability in Q + Noise
So, how do you lower business risk?

16

Uday Damodaran
XLRI Jamshedpur

Risk: 3. Capital Structure!

E
c
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TOP

LINE

EBIT

PAT

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Uday Damodaran
XLRI Jamshedpur

Degree of Financial Leverage

SALES
VAR. COST

Firm 1

Firm 2 Firm 1

Firm 2

Firm 1

Firm 2

Base

Base

( I)

(I)

(II)

(II)

100

100

200

200

50

50

70

70

140

140

35

35

FIXED COST

10

10

10

10

10

10

EBIT

20

20

50

50

15

15

15

PBT

15

Tax

7.5

PAT
EPS

INTEREST

45

35

-10

2.5

22.5

17.5

-5

7.5

2.5

22.5

17.5

-5

0.5

0.5

1.5

3.5

-1

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Uday Damodaran
XLRI Jamshedpur

Structural Risk
E
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y

Proxy?
TOP

LINE

EBIT

Proxy?
BOTTOM LINE

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Uday Damodaran
XLRI Jamshedpur

And thus.

(Aswath Damodaran)the levered beta, which is also the beta

for an equity investment in a firm or the equity beta, is
determined both by the riskiness of the business it operates
in and by the amount of financial leverage it has taken on

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Uday Damodaran
XLRI Jamshedpur

Capital Budgeting and Risk

Cost of equity f(Beta equity)

Beta equity f(Cyclicality, Operating Leverage, Financial
Leverage)
Cost of capital f(Beta asset)
Beta assets f(Cyclicality, Operating Leverage)

Got it?
21

Uday Damodaran
XLRI Jamshedpur

Betas: Levered and Unlevered

Beta Equity is also called Beta Levered and Beta Assets

becomes Beta Unlevered

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Uday Damodaran
XLRI Jamshedpur

Relationship between beta levered and beta unlevered

L = u (1 + D/E )

Got it?
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Uday Damodaran
XLRI Jamshedpur

Bottom Up Betas

Estimate betas for comparable firms; compute average beta

and average leverage
Un-lever the average beta by taking the average levered beta
and using average financial leverage
Compute the bottom up unlevered beta for the firm by taking a
weighted average of the unlevered betas for the businesses
that the firm operates in
Compute the leveraged beta for the firm using its financial
leverage

Lowers standard error [to s .e / sqrt(n)]!

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