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
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
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
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
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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