Weighted Average Cost of Capital ("WACC") is often used as a discount rate to present value a series of future free cash flows of a business in deriving the Enterprise Value.
WACC is written as follows:
E /(D+E)* Ke + D/(D+E)* Kd (1-tax) , where:
E = Equity D = Debt tax = statutory tax rate
Ke = Cost of Equity
Kd = Cost of Debt
This newsletter discusses about βeta - one of the important components in Ke. Under Capital Asset Pricing Model, investment risk is broadly classified into two categories: systematic risk and unsystematic risk. Systematic risk is market-related risk that arises from changes in macroeconomic & market conditions; while unsystematic risk is firm-specific risk which is diversifiable from marginal investors' stand point. One key point to note is that investors are to be compensated for undiversifiable systematic risk.
In general, equity securities are perceived to be riskier assets as compared to risk-free assets such as treasury bonds. Accordingly, market participants will require a premium (in addition to risk free rate) for taking on the additional risk arising from investment into the equity market. In CAPM, cost of equity (Ke) is written as the expected required return of a well-diversified investor for investing in equity shares, as below:
The expected return required by an investor does not stop at Equity Risk Premium (which deals mainly with systematic risk in the market). As investors invest into a specific share in the equity market, βeta is added as a risk adjusting factor to reflect relative volatility of the return of that specific share to the overall return of equity market, represented by market index. Thereby investors will be able to gage how much risk that equity investment will affect the portfolio.
βeta of a publicly-listed company can be calculated by regressing the return of share against the market index of Stock Exchange, representing a market portfolio and over a reasonably long period of time. For illustration, 31 sanitised data points of share price of Company A and Equity Market Index of EX were used (Exhibit aa) to form a linear regression (Exhibit bb) below.
Exhibit aa:
Exhibit bb:
The regression line is read as follows:
y = 2.1395x + 0.0027 and R² = 0.9443
This gives βeta of Company A, being the slope of the linear line, at 2.1395; and SQRT of R² at 0.97175.
Based on the linear regression above, here are some observations:
The return of Company A correlates with the return of EX Equity Market Index at R (coefficient correlation) of 0.97175 which is close 1, suggesting a strong correlation between the two.
R² at 0.9443 indicates that the regression line has high explanatory power (goodness of fit), in that 94.43% of the movements (or variances) in Company A's share price is attributable to the fluctuations in EX Market Index (independent variable). 5.57% of the variances is caused by other variables which are not examined in this model. In another word, Company A's share return follows largely the changes in return of EX market index.
However, given that Company A's βeta > 1 , it also suggests that the relative return of Company A is 2.14 times risker/ more volatile than that of the return of EX Market Index. For instance, if market as a whole is experiencing a shock thus market index tumbles abruptly, one would expect that the effect of this market shock be amplified twice more aggressive on the share price of Company A.
Many literatures explained that βeta of a firm is determined by the types of business/industry the firm is operating in, for eg how sensitive the business is towards changes in economic conditions, firm's operating cost structure (flexibility to move away from fixed cost to variable cost structure), its business fundamentals and degree of financial leverage. Moreover, when a public firm is run by a management team of which the investor has neither influence nor control over - all these are perceived as risks to be borne by the investors. Therefore in theory, these perceived risks, measured by βeta, are to be priced in by any rational investors to the required return of an equity investment. This explains the inclusion of βeta as risk-adjuster in the equation of cost of equity.
We assist companies to compute the returns of projects and discount rate for unquoted investments for internal decision & financial reporting purposes.
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