- July 29, 2022
- Posted by: Ramkumar
- Category: Posts

Beta In DCF Valuation
๐๐๐ญ๐ ๐ข๐ง ๐ ๐๐๐ ๐๐๐ฅ๐ฎ๐๐ญ๐ข๐จ๐ง 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 ๐ณ๐ถ๐ฟ๐บ ๐๐ถ๐๐ต ๐๐ต๐ฒ ๐ฎ๐ฏ๐ผ๐๐ฒ ๐ฐ๐ต๐ฎ๐ฟ๐ฎ๐ฐ๐๐ฒ๐ฟ๐ถ๐๐๐ถ๐ฐ๐ ๐ฐ๐ฎ๐ฟ๐ฟ๐ถ๐ฒ๐ ๐ฎ ๐ต๐ถ๐ด๐ต๐ฒ๐ฟ ๐ฒ๐พ๐๐ถ๐๐ ๐ฐ๐ผ๐๐. However, analysts assume debt and cash have a beta of zero.
For cash, if invested in riskless securities, the risk is zero. ๐๐ผ๐๐ฒ๐๐ฒ๐ฟ, ๐ฎ ๐๐ฒ๐ฟ๐ผ ๐ฏ๐ฒ๐๐ฎ ๐บ๐ฎ๐ ๐ป๐ผ๐ ๐ฎ๐น๐๐ฎ๐๐ ๐ฏ๐ฒ ๐๐ต๐ฒ ๐ฐ๐ฎ๐๐ฒ ๐ณ๐ผ๐ฟ ๐ฑ๐ฒ๐ฏ๐.
For firms that ๐๐๐๐๐ ๐๐๐๐๐๐๐๐๐๐-๐๐๐๐ ๐ ๐ ๐๐๐ (๐๐๐๐ ๐๐ ๐๐๐๐๐๐ ๐๐๐๐๐๐ ๐๐๐๐ ๐ฉ๐๐), 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, ๐๐ช๐ฎ๐ข๐ญ๐ฒ ๐๐๐๐จ๐ฆ๐๐ฌ ๐ ๐๐๐ฅ๐ฅ ๐จ๐ฉ๐ญ๐ข๐จ๐ง ๐จ๐ง ๐ญ๐ก๐ ๐๐ง๐ญ๐๐ซ๐ฉ๐ซ๐ข๐ฌ๐ ๐ฏ๐๐ฅ๐ฎ๐ ๐ข๐ง ๐ฌ๐ฎ๐๐ก ๐ ๐ฌ๐๐๐ง๐๐ซ๐ข๐จ.
Let me substantiate. For instance, in a highly levered firm, when
๐๐ป๐๐ฒ๐ฟ๐ฝ๐ฟ๐ถ๐๐ฒ ๐๐ฎ๐น๐๐ฒ > ๐๐ฎ๐ฐ๐ฒ ๐๐ฎ๐น๐๐ฒ ๐ผ๐ณ ๐ฑ๐ฒ๐ฏ๐ -> ๐๐พ๐๐ถ๐๐ ๐ต๐ฎ๐ ๐ฎ ๐๐ฎ๐น๐๐ฒ
๐๐ป๐๐ฒ๐ฟ๐ฝ๐ฟ๐ถ๐๐ฒ ๐๐ฎ๐น๐๐ฒ < ๐๐ฎ๐ฐ๐ฒ ๐๐ฎ๐น๐๐ฒ ๐ผ๐ณ ๐ฑ๐ฒ๐ฏ๐ -> ๐๐พ๐๐ถ๐๐ ๐ต๐ฎ๐ ๐๐ฒ๐ฟ๐ผ ๐๐ฎ๐น๐๐ฒ
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.