Unlevered Beta

Definition

Unlevered Beta, also known as asset beta, is a measure of market risk of a company without considering its financial leverage. It calculates the risk of a firm’s equity without the impact of its capital structure, specifically debt. Essentially, it shows the volatility or risk of a company in the market, assuming it has no debt.

Phonetic

The phonetics of the keyword “Unlevered Beta” is: ʌnˈlɛvərd beɪtə

Key Takeaways

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1. Measurement of Business Risk: Unlevered Beta, also known as Asset Beta, is widely used to measure the business risk of a company. It provides the risk of a firm’s equity without considering its debt (financial risk). It helps stakeholders in understanding the volatility of the firm’s equity returns relative to a market index.
2. Utility in Comparisons: Unlevered Beta is helpful when comparing the risk of companies with different capital structures. Since it eliminates debt from the equation, it allows stakeholders to compare companies purely on their operational risk.
3. Relevance in CAPM: In the context of the Capital Asset Pricing Model (CAPM), Unlevered Beta helps in assessing the cost of equity for a project or an entire firm (by unlevering the equity Beta of a comparable firm). This can help in more precise investment decisions.

Importance

Unlevered Beta, also known as asset beta, is a crucial concept in finance and business because it is a measure of the systematic risk of a company’s equity without considering indebtedness or financial leverage. By removing the effects of financial leverage, unlevered beta helps investors and analysts understand the inherent or pure risk that a firm’s equity presents. It indicates how much risk a company’s equity has relative to the market or a comparable company as if it had no debt. Therefore, when investors aim to compare the risks of different companies on a similar footing, they use unlevered beta. Additionally, it is also employed heavily in the weighted average cost of capital (WACC) calculations used in company valuations and capital budgeting.

Explanation

The Unlevered Beta, also known as Asset Beta, plays a significant role in corporate finance to evaluate the potential risks associated with investment in a company. It is used to measure the market risk of the firm, which enables investors, lenders, and financial analysts to understand the volatility or business risk inherent to the firm unrelated to its debt structure. This measurement helps to give a sense of potential volatility and risk associated with the company’s equity in an assumption where no debt exists.Unlevered Beta is widely employed in business valuations, specifically in discount cash flow (DCF) models to calculate the weighted average cost of capital. Unlevered Beta provides a more accurate picture of systemic risk as it essentially reflects only the more unsystematic nature of the business by removing the financial risk. Therefore, the primary roles of the Unlevered Beta are to illustrate a firm’s general risk compared to the market and inform investment decisions. The tool is valuable to investors and analysts as it serves as a benchmark for comparing the volatility of different investments and calculating the expected rate of return.

Examples

Unlevered beta, also referred to as the asset beta, demonstrates the market risk of a company without considering its financial leverage. It indicates how much risk a firm’s equity has when there is no debt. Here are three real-world examples relating to this term:1. Apple Inc.: In 2021, Apple’s levered beta was approximately 1.20, but its unlevered beta was about 0.80. This suggested that without considering debt, Apple’s stock had 80% of the market’s volatility. Apple’s lower unlevered beta showed that it had less inherent risk in its equity than what it appeared with the debt included.2. Pfizer Inc.: The pharmaceutical company Pfizer had a levered beta of approximately 0.65 in 2021 and an unlevered beta of approximately 0.25. The company’s much lower unlevered beta implies that if Pfizer was completely equity funded, it would be much less volatile and risky than a typical company in the stock market.3. Alphabet Inc. (Google’s parent company): Alphabet had a levered beta of 1.03 and an unlevered beta of 0.86 in 2021. The relatively close values of Alphabet’s unlevered and levered beta suggest that the firm’s debt does not significantly amplify the equity risk for the company shareholders. Remember that these figures can fluctuate over time due to changes in the company’s financial structure, industry risk, and market volatility.

Frequently Asked Questions(FAQ)

Related Finance Terms

• Capital Asset Pricing Model (CAPM): This is a finance model that allows investors to calculate the expected return on an investment based on its systematic risk profile. Unlevered Beta is an essential component of this model.
• Levered Beta: Also known as equity beta, it is the sensitivity of a firm’s stock returns to changes in the market, considering both the business risk and financial risk. It contrasts to Unlevered Beta, which only takes into account the business risk.
• Systematic Risk: This is the overall risk that affects all companies in the market, also referred to as market risk. Unlevered Beta is used to measure a company’s specific systematic risk.
• Risk-Free Rate: The theoretical rate of return of an investment with no risk. This rate is often used in CAPM calculations and is relevant when interpreting Unlevered Beta.
• Debt-to-Equity Ratio: This is a financial ratio indicating the relative proportion of shareholders’ equity and debt used to finance a company’s assets. This ratio is fundamental when transitioning from Levered Beta to Unlevered Beta.

Sources for More Information

• Investopedia
• Corporate Finance Institute
• Wall Street Mojo
• Fidelity