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Bottom Up Beta

This document discusses bottom-up approaches to estimating betas and relative risk. It explains that bottom-up betas are estimated by breaking a firm down into its underlying businesses, estimating the unlevered beta of each business based on comparable firms, adjusting for operating and financial leverage, and weighting the results. This bottom-up approach provides more accurate betas with lower standard errors than regression betas. It also allows betas to be adjusted over time as a firm's business mix and leverage change. The document provides an example of estimating the bottom-up beta for Embraer by looking at its aerospace business.

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Fatima Khandwala
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240 views9 pages

Bottom Up Beta

This document discusses bottom-up approaches to estimating betas and relative risk. It explains that bottom-up betas are estimated by breaking a firm down into its underlying businesses, estimating the unlevered beta of each business based on comparable firms, adjusting for operating and financial leverage, and weighting the results. This bottom-up approach provides more accurate betas with lower standard errors than regression betas. It also allows betas to be adjusted over time as a firm's business mix and leverage change. The document provides an example of estimating the bottom-up beta for Embraer by looking at its aerospace business.

Uploaded by

Fatima Khandwala
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd
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Bottom up beta

Determinants of Betas & Relative Risk

Aswath Damodaran 2
In a perfect world… we would estimate the beta
of a firm by doing the following

Aswath Damodaran 3
Adjusting for operating leverage…
• Within any business, firms with lower fixed costs (as a
percentage of total costs) should have lower unlevered
betas. If you can compute fixed and variable costs for
each firm in a sector, you can break down the unlevered
beta into business and operating leverage components.
• Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable
costs))
• The biggest problem with doing this is informational. It is
difficult to get information on fixed and variable costs for
individual firms.
• In practice, we tend to assume that the operating
leverage of firms within a business are similar and use
the same unlevered beta for every firm.

Aswath Damodaran 4
Adjusting for financial leverage…
Conventional approach: If we assume that debt carries no
market risk (has a beta of zero), the beta of equity alone can
be written as a function of the unlevered beta and the debt-
equity ratio
L = u (1+ ((1-t)D/E))
In some versions, the tax effect is ignored and there is no (1-t) in the
equation.
Debt Adjusted Approach: If beta carries market risk and you
can estimate the beta of debt, you can estimate the levered
beta as follows:
L = u (1+ ((1-t)D/E)) - debt (1-t) (D/E)
While the latter is more realistic, estimating betas for debt can be
difficult to do.

Aswath Damodaran 5
Bottom-up Betas

Aswath Damodaran 6
Why bottom-up betas?
• The standard error in a bottom-up beta will be significantly
lower than the standard error in a single regression beta.
Roughly speaking, the standard error of a bottom-up beta
estimate can be written as follows:
Std error of bottom-up beta =

• The bottom-up beta can be adjusted to reflect changes in the


firm’s business mix and financial leverage. Regression betas
reflect the past.
• You can estimate bottom-up betas even when you do not have
historical stock prices. This is the case with initial public
offerings, private businesses or divisions of companies.

Aswath Damodaran 7
Estimating Bottom Up Betas & Costs of
Equity: Vale

Aswath Damodaran
Embraer’s Bottom-up Beta
Business Unlevered Beta D/E RatioLevered beta
Aerospace 0.95 18.95% 1.07

Levered Beta = Unlevered Beta ( 1 + (1- tax rate)


(D/E Ratio)
= 0.95 ( 1 + (1-.34) (.1895)) = 1.07

Aswath Damodaran 9

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