RELATIVE RISK MEASURES

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The CAPM Beta: The Most Used
(and Misused) Risk Measure
The standard procedure for estimating betas is to
regress stock returns (Rj) against market returns (Rm) -
Rj = a + b Rm
where a is the intercept and b is the slope of the regression.
The slope of the regression corresponds to the beta of
the stock, and measures the riskiness of the stock.
This beta has three problems:
• It has high standard error
• It reflects the firm’s business mix over the period of the
regression, not the current mix
• It reflects the firm’s average financial leverage over the
period rather than the current leverage.

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Unreliable, when it looks bad..

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Or when it looks good..

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 One slice of history..

During this time period, Valeant was a

stock under siege, without a CEO,
under legal pressure & lacking
financials.

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And subject to game playing

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Measuring Relative Risk: You don’t like betas or
modern portfolio theory? No problem.

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Don’t like the diversified investor
focus, but okay with price-based
measures
1. Relative Standard Deviation
• Relative Volatility = Std dev of Stock/ Average Std dev across all stocks
• Captures all risk, rather than just market risk
2. Proxy Models
• Look at historical returns on all stocks and look for variables that explain
differences in returns.
• You are, in effect, running multiple regressions with returns on individual
stocks as the dependent variable and fundamentals about these stocks
as independent variables.
• This approach started with market cap (the small cap effect) and over
the last two decades has added other variables (momentum, liquidity
etc.)
3. CAPM Plus Models
• Start with the traditional CAPM (Rf + Beta (ERP)) and then add other
premiums for proxies.

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Don’t like the price-based
approach..
1. Accounting risk measures: To the extent that you don’t trust
market-priced based measures of risk, you could compute
relative risk measures based on
• Accounting earnings volatility: Compute an accounting beta or relative volatility
• Balance sheet ratios: You could compute a risk score based upon accounting
ratios like debt ratios or cash holdings (akin to default risk scores like the Z score)

2. Qualitative Risk Models: In these models, risk assessments are

based at least partially on qualitative factors (quality of
management).
3. Debt based measures: You can estimate a cost of equity,
based upon an observable costs of debt for the company.
• Cost of equity = Cost of debt * Scaling factor
• The scaling factor can be computed from implied volatilities.

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Determinants of Betas &
Relative Risk

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In a perfect world… we would estimate the
beta of a firm by doing the following

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Adjusting for operating
leverage…
Within any business, firms with lower fixed costs (as a
percentage of total costs) should have lower unlevered
betas. If you can compute fixed and variable costs for each
firm in a sector, you can break down the unlevered beta into
business and operating leverage components.
◦ Unlevered beta = Pure business beta * (1 + (Fixed costs/ Variable
costs))
The biggest problem with doing this is informational. It is
difficult to get information on fixed and variable costs for
individual firms.
In practice, we tend to assume that the operating leverage
of firms within a business are similar and use the same
unlevered beta for every firm.

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Adjusting for financial
leverage…
 Conventional approach: If we assume that debt carries no market risk
(has a beta of zero), the beta of equity alone can be written as a
function of the unlevered beta and the debt-equity ratio
L = u (1+ ((1-t)D/E))
In some versions, the tax effect is ignored and there is no (1-t) in the
equation.
 Debt Adjusted Approach: If beta carries market risk and you can
estimate the beta of debt, you can estimate the levered beta as
follows:
L = u (1+ ((1-t)D/E)) - debt (1-t) (D/E)
While the latter is more realistic, estimating betas for debt can be difficult to
do.

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Bottom-up Betas

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Why bottom-up betas?
The standard error in a bottom-up beta will be significantly lower
than the standard error in a single regression beta. Roughly
speaking, the standard error of a bottom-up beta estimate can be
written as follows:
Std error of bottom-up beta = Average Std Error across Betas
Number of firms in sample
The bottom-up beta can be adjusted to reflect changes in the
firm’s business mix and financial leverage. Regression betas
reflect the past.
You can estimate bottom-up betas even when you do not have
historical stock prices. This is the case with initial public offerings,
private businesses or divisions of companies.

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 Estimating Bottom Up Betas &
Costs of Equity: Vale
Sample Unlevered beta Peer Group Value of Proportion of
Business Sample size of business Revenues EV/Sales Business Vale

Global firms in metals &

Metals & mining, Market cap>$1
Mining billion 48 0.86 $9,013 1.97 $17,739 16.65%

Iron Ore Global firms in iron ore 78 0.83 $32,717 2.48 $81,188 76.20%

Global specialty
Fertilizers chemical firms 693 0.99 $3,777 1.52 $5,741 5.39%

Global transportation
Logistics firms 223 0.75 $1,644 1.14 $1,874 1.76%
Vale
Operations 0.8440 $47,151 $106,543 100.00%

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Embraer’s Bottom-up Beta
BusinessUnlevered Beta D/E Ratio Levered beta
Aerospace 0.95 18.95% 1.07

 Levered Beta = Unlevered Beta ( 1 + (1- tax rate) (D/E Ratio)

= 0.95 ( 1 + (1-.34) (.1895)) = 1.07

 Can an unlevered beta estimated using U.S. and European aerospace

companies be used to estimate the beta for a Brazilian aerospace
company?
a. Yes
b. No
What concerns would you have in making this assumption?

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Gross Debt versus Net Debt
Approaches
Analysts in Europe and Latin America often take the difference between
debt and cash (net debt) when computing debt ratios and arrive at very
different values.
For Embraer, using the gross debt ratio
◦ Gross D/E Ratio for Embraer = 1953/11,042 = 18.95%
◦ Levered Beta using Gross Debt ratio = 1.07
Using the net debt ratio, we get
◦ Net Debt Ratio for Embraer = (Debt - Cash)/ Market value of Equity
= (1953-2320)/ 11,042 = -3.32%
◦ Levered Beta using Net Debt Ratio = 0.95 (1 + (1-.34) (-.0332)) = 0.93
The cost of Equity using net debt levered beta for Embraer will be much
lower than with the gross debt approach. The cost of capital for Embraer
will even out since the debt ratio used in the cost of capital equation will
now be a net debt ratio rather than a gross debt ratio.

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The Cost of Equity: A Recap

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