Beta In DCF Valuation

Beta In DCF Valuation

๐๐ž๐ญ๐š ๐ข๐ง ๐š ๐ƒ๐‚๐… ๐•๐š๐ฅ๐ฎ๐š๐ญ๐ข๐จ๐ง is a critical component to assess the risk of a business and thus becomes crucial to determine a firm’s value. A firm with a higher beta (higher risk) usually has the following characteristics:

1)High financial leverage
2)High Operating leverage
3)Operate in cyclical industries
4)Sell discretionary goods/services

Thus, in the CAPM in DCF, a ๐—ณ๐—ถ๐—ฟ๐—บ ๐˜„๐—ถ๐˜๐—ต ๐˜๐—ต๐—ฒ ๐—ฎ๐—ฏ๐—ผ๐˜ƒ๐—ฒ ๐—ฐ๐—ต๐—ฎ๐—ฟ๐—ฎ๐—ฐ๐˜๐—ฒ๐—ฟ๐—ถ๐˜€๐˜๐—ถ๐—ฐ๐˜€ ๐—ฐ๐—ฎ๐—ฟ๐—ฟ๐—ถ๐—ฒ๐˜€ ๐—ฎ ๐—ต๐—ถ๐—ด๐—ต๐—ฒ๐—ฟ ๐—ฒ๐—พ๐˜‚๐—ถ๐˜๐˜† ๐—ฐ๐—ผ๐˜€๐˜. However, analysts assume debt and cash have a beta of zero.

For cash, if invested in riskless securities, the risk is zero. ๐—›๐—ผ๐˜„๐—ฒ๐˜ƒ๐—ฒ๐—ฟ, ๐—ฎ ๐˜‡๐—ฒ๐—ฟ๐—ผ ๐—ฏ๐—ฒ๐˜๐—ฎ ๐—บ๐—ฎ๐˜† ๐—ป๐—ผ๐˜ ๐—ฎ๐—น๐˜„๐—ฎ๐˜†๐˜€ ๐—ฏ๐—ฒ ๐˜๐—ต๐—ฒ ๐—ฐ๐—ฎ๐˜€๐—ฒ ๐—ณ๐—ผ๐—ฟ ๐—ฑ๐—ฒ๐—ฏ๐˜.

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For firms that ๐’„๐’‚๐’“๐’“๐’š ๐’Š๐’๐’—๐’†๐’”๐’•๐’Ž๐’†๐’๐’•-๐’ˆ๐’“๐’‚๐’…๐’† ๐’…๐’†๐’ƒ๐’• (๐’„๐’“๐’†๐’…๐’Š๐’• ๐’“๐’‚๐’•๐’Š๐’๐’ˆ ๐’‰๐’Š๐’ˆ๐’‰๐’†๐’“ ๐’•๐’‰๐’‚๐’ ๐‘ฉ๐’‚๐’‚), the debt value is independent of the firm’s value. However, for firms with a credit rating below Baa, the intrinsic value of debt is at a significant discount to its book value and will fluctuate with the enterprise value. Thus, ๐ž๐ช๐ฎ๐ข๐ญ๐ฒ ๐›๐ž๐œ๐จ๐ฆ๐ž๐ฌ ๐š ๐œ๐š๐ฅ๐ฅ ๐จ๐ฉ๐ญ๐ข๐จ๐ง ๐จ๐ง ๐ญ๐ก๐ž ๐ž๐ง๐ญ๐ž๐ซ๐ฉ๐ซ๐ข๐ฌ๐ž ๐ฏ๐š๐ฅ๐ฎ๐ž ๐ข๐ง ๐ฌ๐ฎ๐œ๐ก ๐š ๐ฌ๐œ๐ž๐ง๐š๐ซ๐ข๐จ.

Let me substantiate. For instance, in a highly levered firm, when

๐—˜๐—ป๐˜๐—ฒ๐—ฟ๐—ฝ๐—ฟ๐—ถ๐˜€๐—ฒ ๐˜ƒ๐—ฎ๐—น๐˜‚๐—ฒ > ๐—™๐—ฎ๐—ฐ๐—ฒ ๐˜ƒ๐—ฎ๐—น๐˜‚๐—ฒ ๐—ผ๐—ณ ๐—ฑ๐—ฒ๐—ฏ๐˜ -> ๐—˜๐—พ๐˜‚๐—ถ๐˜๐˜† ๐—ต๐—ฎ๐˜€ ๐—ฎ ๐˜ƒ๐—ฎ๐—น๐˜‚๐—ฒ
๐—˜๐—ป๐˜๐—ฒ๐—ฟ๐—ฝ๐—ฟ๐—ถ๐˜€๐—ฒ ๐˜ƒ๐—ฎ๐—น๐˜‚๐—ฒ < ๐—™๐—ฎ๐—ฐ๐—ฒ ๐˜ƒ๐—ฎ๐—น๐˜‚๐—ฒ ๐—ผ๐—ณ ๐—ฑ๐—ฒ๐—ฏ๐˜ -> ๐—˜๐—พ๐˜‚๐—ถ๐˜๐˜† ๐—ต๐—ฎ๐˜€ ๐˜‡๐—ฒ๐—ฟ๐—ผ ๐˜ƒ๐—ฎ๐—น๐˜‚๐—ฒ

Depending on the probability of the occurrence of each scenario, we arrive at the equity value. For example, during the #covid19crisis, i valued airline firms and brick-and-mortar retail companies with the above approach, treating the equity as a call option by giving a probability that these companies will survive the crisis or go bankrupt.



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