Beta In DCF Valuation

Beta In DCF Valuation

𝐁𝐞𝐭𝐚 𝐢𝐧 𝐚 𝐃𝐂𝐅 𝐕𝐚𝐥𝐮𝐚𝐭𝐢𝐨𝐧 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 𝗳𝗶𝗿𝗺 𝘄𝗶𝘁𝗵 𝘁𝗵𝗲 𝗮𝗯𝗼𝘃𝗲 𝗰𝗵𝗮𝗿𝗮𝗰𝘁𝗲𝗿𝗶𝘀𝘁𝗶𝗰𝘀 𝗰𝗮𝗿𝗿𝗶𝗲𝘀 𝗮 𝗵𝗶𝗴𝗵𝗲𝗿 𝗲𝗾𝘂𝗶𝘁𝘆 𝗰𝗼𝘀𝘁. However, analysts assume debt and cash have a beta of zero.

For cash, if invested in riskless securities, the risk is zero. 𝗛𝗼𝘄𝗲𝘃𝗲𝗿, 𝗮 𝘇𝗲𝗿𝗼 𝗯𝗲𝘁𝗮 𝗺𝗮𝘆 𝗻𝗼𝘁 𝗮𝗹𝘄𝗮𝘆𝘀 𝗯𝗲 𝘁𝗵𝗲 𝗰𝗮𝘀𝗲 𝗳𝗼𝗿 𝗱𝗲𝗯𝘁.

For firms that 𝒄𝒂𝒓𝒓𝒚 𝒊𝒏𝒗𝒆𝒔𝒕𝒎𝒆𝒏𝒕-𝒈𝒓𝒂𝒅𝒆 𝒅𝒆𝒃𝒕 (𝒄𝒓𝒆𝒅𝒊𝒕 𝒓𝒂𝒕𝒊𝒏𝒈 𝒉𝒊𝒈𝒉𝒆𝒓 𝒕𝒉𝒂𝒏 𝑩𝒂𝒂), 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, 𝐞𝐪𝐮𝐢𝐭𝐲 𝐛𝐞𝐜𝐨𝐦𝐞𝐬 𝐚 𝐜𝐚𝐥𝐥 𝐨𝐩𝐭𝐢𝐨𝐧 𝐨𝐧 𝐭𝐡𝐞 𝐞𝐧𝐭𝐞𝐫𝐩𝐫𝐢𝐬𝐞 𝐯𝐚𝐥𝐮𝐞 𝐢𝐧 𝐬𝐮𝐜𝐡 𝐚 𝐬𝐜𝐞𝐧𝐚𝐫𝐢𝐨.

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

𝗘𝗻𝘁𝗲𝗿𝗽𝗿𝗶𝘀𝗲 𝘃𝗮𝗹𝘂𝗲 > 𝗙𝗮𝗰𝗲 𝘃𝗮𝗹𝘂𝗲 𝗼𝗳 𝗱𝗲𝗯𝘁 -> 𝗘𝗾𝘂𝗶𝘁𝘆 𝗵𝗮𝘀 𝗮 𝘃𝗮𝗹𝘂𝗲
𝗘𝗻𝘁𝗲𝗿𝗽𝗿𝗶𝘀𝗲 𝘃𝗮𝗹𝘂𝗲 < 𝗙𝗮𝗰𝗲 𝘃𝗮𝗹𝘂𝗲 𝗼𝗳 𝗱𝗲𝗯𝘁 -> 𝗘𝗾𝘂𝗶𝘁𝘆 𝗵𝗮𝘀 𝘇𝗲𝗿𝗼 𝘃𝗮𝗹𝘂𝗲

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.