Bottom-up beta instead of Regression Beta ( for entire pdf of UTX valuation just comment your mail id in the comment section )

· Summary: 

Regression beta reflects the past business mix and financial leverage where valuation is a forward-looking approach it gives a clearer picture about entity value drive and Beauty about bottom-up beta can be calculated even when you do not have Historical stock prices.

1. The standard error of the bottom-up beta will be significantly lower than the single error in a single regression beta.
2. The standard Error of Bottom-up beta can be written as follows: -

Standard error of bottom-up beta = Average standard error across betas / Number of firms in the sample.

Beta Measure the risk of enterprise in relation to Market:-

What Is Beta?

Beta is a measure of the volatility—or systematic risk—of a security or portfolio compared to the market as a whole. Beta is used in the capital asset pricing model (CAPM), which describes the relationship between systematic risk and expected return for assets (usually stocks). CAPM is widely used as a method for pricing risky securities and for generating estimates of the expected returns of assets, considering both the risk of those assets and the cost of capital.

How Beta Works

A beta coefficient can measure the volatility of an individual stock compared to the systematic risk of the entire market. In statistical terms, beta represents the slope of the line through a regression of data points. In finance, each of these data points represents an individual stock's returns against those of the market as a whole.

Beta effectively describes the activity of a security's returns as it responds to swings in the market. A security's beta is calculated by dividing the product of the covariance of the security's returns and the market's returns by the variance of the market's returns over a specified period.

The calculation for beta is as follows:

Beta coefficient(β)= Covariance(Re ,Rm)/ Variance(Rm )

where:

Re =the return on an individual stock

Rm =the return on the overall market

Covariance=how changes in a stock’s returns are related to changes in the market’s returns

Variance=how far the market’s data points spread out from their average value

Types of Beta Values and interpretation:-

Beta has a co-relation with the market with the range of -1 to 1, what does it mean by that if you have a beta of 0 it mean you do not have any co-relation, and if it has -1 then it perfectly negative co-relation ( that if the index move by 10% in upside then it means your stock would move 10% downside ) and if the beta is +1 that mean perfectly positive co- related (that if the index move by 10% in upside then it mean your stock would move 10% upside).

·        5 Step process of Estimating Bottom-Up Beta:-

1.     As beta of the portfolio is = " sum of the weighted average beta of all individual securities "

2.     similarly, Beta of Firm is = "sum of the weighted average beta of all the different business it is in."

·        Step 1:-

find the business or business that your firm operates in like for Proctor and gamble it could be 

A. household

B. Cosmetic etc.

·        synchronizing with an example of UTX:-

there is a Co. Called UTX which business Brokedown in 4 parts majorly

 1. Engineering and Construction  

 2. Building material

 3. Machinery

 4. Aerospace and Defence

Tip:- you can easily get the breakdown in 10K of Co. SEC Filing

·        Step 2:-

A. find the Publicly traded firms in Each business and obtain their Regression Betas; compute the simple average across these betas to arrive at an Average beta for these publicly traded firms.

B. Unlevered the average beta using the average DE ratio across the public traded firms in the sample.

C. Unlevered beta for business = Average beta across public-traded firms / ( 1+(1-t)(Average DE ratio across firms).

·        Step 3:- 

Estimate how much value your firm drives from each of the businesses it is in.

A. Refinement level 1:- If you can adjust this beta for the difference between your firm and the comparable firms on operating leverage and product characteristics.

A. Refinement level 2: While revenue or operating income are often used as weights; it is better to estimate each business's value.

Note:- this step is about to compute the weight for which we require two things ;

1.     Revenue from each business or segment and

2.     EV/SALES ratio from each business.

Product of both elements would fetch us a value of each business for Weight Purpose.

·        synchronizing with an example of UTX (United Technology Corporation):-

So UTX in a different type of business it means revenue being drive by different segment so it's better to use different undelivered beta for the different sector and then levered back with our current or expected capital weight.

However, we should use the value weight of EV/sales ratio as its helps to understand that how much revenue drives the Enterprise value for a particular segment.

Below I am providing the information of valuation that I did in 2018 for UTX:-

·        Step 4:- Compute the Weighted Average of the Unlevered beta of different businesses

Unlevered beta * Value weight ( STEP 3) Therefore bottom-up levered beta for your firm = sum of Weighted average of the un-levered betas of the individual business.

as you can see in the above image (1.1057)

Taking control of your Mix:-

Note:-"If you expect your firm business mix to get change over time then you can change the weight on year to year basis.

·        Step 5:- Compute the levered beta ( Equity Beta) for your Firm using the market debt to Equity Ratio for your firm. see below computation with SAP Example.

Levered beta = Unlevered beta (1+(1-t)(DE ratio) for UTX

1.11(1+(1-0.2310)(0.2469)=1.29(Round off Difference , Tax rate effective-23.10, DE ratio=0.2469)

Refinement = If you expect DE Ratio to change over time then levered beta will change over time

Determinants of Beta:-

1. Nature of Product and Services offered by Company.
2. Operating Leverage ( Fixed cost as a % of total cost):- Other things same, greater the proportion of the cost that is fixed. higher the beta of the company. so let's talk about effects and implications:-

·        high infrastructure needs company need higher beta than flexible cost structure.

·        smaller firms should have high beta than large firms

·       young companies should have high beta than mature companies.

Lots of fixed costs good times become great, bad times become great pain, everything gets magnified ( High FC ----- High beta)

3. Financial Leverage:- Other things same, the higher the debt funding in the capital finance, the higher the equity beta will be.

It means the highly levered firm should have a high beta as compared to fewer debt firms.

The formula for Levered beta:-

Unlevered Beta (1+(1-t)(DE Ratio)

Tip:- Interest Expense always lowers the net income but the fact is firm uses debt instead of equity implies that the number of shares will also be lower. thus the benefit of debt shows up in the EPS.

Higher Leverage increases the Variance in the EPS and makes Equity investment Riskier.

Conclusion:-

Modern valuation practices involve the segmented valuation of a company. Implying a different beta for different segments. A major benefit of bottom-up beta over regression is that it does not create a statistical mess of combining different risk-reward segments. However, as I said when the valuation of all segments is done differently so this drawback of regression beta also withdraws.

References:-Aswath Damodaran ( Damodaran on valuation ), Wikipedia, Research website on equity.