In the process of calculating a weighted average cost of capital for a discounted cash flow analysis, a Beta must often be generated. Let’s take a look at the process.
Calculating Beta is the fun part of the Capital Asset Pricing Model (CAPM). Since Beta is a measure of how well a stock is doing with the broader market, I would calculate it by doing a regression analysis of the stock’s performance against a broad index like the S&P 500. Fortunately, many stock information services like Bloomberg or Yahoo Finance we have already calculated this value for stocks.
The problem with these Betas is that they are leveraged. We need an unlevered security for our cost of capital calculation. The reason we need this value without leverage is that the amount of debt or leverage a company has can affect its Beta. And since a potential buyer of a company could choose to significantly modify its capital structure, we need to remove the effect of leverage to get a better idea of the value of the company.
Deleveraging a Beta
Deleveraging a Beta can be a complicated process. The formula for an unlocked Beta is as follows:
Unlevered Beta = Stock Beta / [ 1 + (1 – tax rate) * Debt / Equity]
The Equity Beta would be the Beta you get from Yahoo Finance on the Key Stats page. You can calculate the business tax rate by dividing tax expense by pre-tax income on the business income statement. Debt is the total debt of the company. Equity in this case is the market value of the company’s equity – its market capitalization.
Beta Compensations
As if calculating a Beta without leverage wasn’t complicated enough, you can’t calculate a Beta for private companies. Instead, we should analyze industry comparables to find an average or median unlevered beta as a proxy for our company’s beta.
What this means is that we need to look up public comps for our company, calculate each of their unlevered Betas, and take an average. We can now use this average beta in our capital asset pricing model and to calculate the weighted average cost of capital.