Estimation of Beta Recall that beta is the sensitivity of a stocks return to

Estimation of beta recall that beta is the

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Estimation of Beta Recall that beta is the sensitivity of a stock’s return to the return on the market portfolio Market portfolio is a portfolio of all assets in the economy In practice, a broad stock market index, such as the S&P Composite, is used to represent the market Beta is conventionally measured with monthly observations over a 5 year period weekly observations over 2 to 5 year periods If the operations of a firm are similar to the operations of the rest of its industry, industry beta may be used Less estimation error compared to individual firm beta Adjusting the industry beta for the company’s financial leverage may be necessary 8
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Estimating β with Regressions Security Returns Return on market R i = a i + β i R m + e i Slope = β i Characteristic Lin e 9
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Determinants of Beta Beta is a measure of responsiveness of a firm’s stock return to that of the market Business Risk Cyclicality of revenues Operating leverage Financial Risk Financial leverage 11
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Cyclicality of Revenues Highly cyclical stocks have higher betas A cyclical firm has revenues and operating income that tend to move together with the state of the economy Airlines and automobile firms fluctuate with the business cycle Groceries and utilities are less dependent upon the business cycle Note that cyclicality is not the same as variability—stocks with high standard deviations need not have high betas 12
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Operating Leverage The degree of operating leverage (DOL) measures how sensitive a firm (or project) is to its fixed costs A firm with high fixed costs ( e.g., property, plant, and equipment ) and low variable costs has a high operating leverage E.g., companies with high R&D costs, such as pharmaceuticals: it can cost billions to develop a drug, but then pennies to produce it Operating leverage magnifies the effect of cyclicality on β Since fixed costs do not change with sales, they make good situations better and bad situations worse, i.e., they “lever” results DOL = EBIT Sales Δ Sales Δ EBIT 13
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