In the process of calculating a weighted average cost of capital for a discounted cash flow analysis, a Beta must often be released. 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 a stock moves with the broader market, I would calculate it by doing a regression analysis of the stock’s performance against a broad index such as the S&P 500. Fortunately, many stock information services such as Bloomberg or Yahoo Finance I have already calculated this value for stocks.
The problem with these Betas is that they are leveraged. We need a value without leverage 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 acquirer of a company might choose to significantly alter its capital structure, we should eliminate the effect of leverage to get a better idea of the value of the company.
Deactivating a Beta
Releasing a beta can be a complicated process. The formula for a Beta without leverage is as follows:
Beta without leverage = Equity Beta / [ 1 + (1 – tax rate) * Debt / Equity]
The Equity Beta would be the Beta you get from Yahoo Finance on the Key Statistics page. You can calculate the business tax rate by dividing tax expenses 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 comps
As if calculating a Beta without leverage isn’t complicated enough, you can’t calculate a Beta for private companies. Instead, we must analyze the industry comparables to find an average or median unlevered Beta as an approximation of our company’s Beta.
What this means is that we need to look up public comps for our company, calculate each of its Betas without leverage, and take an average. We can now use this average beta in our capital asset pricing model and in calculating the weighted average cost of capital.