My Beta Hack
Andrew Meerburg
29 May 2022
I came across a great article about Beta, a key determinant of the discount rate used in business valuations which in turn drives the value of your business. It reminded me of the high-level hack I use when reviewing the Beta used in a business valuation.
To recap, Beta is a measure of the risk of a particular market sector versus the risk of the total market and is measured by how the price of a particular sector moves versus the price of the total market. By means of an example, assuming the total market price is the JSE ALSI, and your sector is the retail sector, then a Beta of 1 would indicate that the price of all retail companies moves by the same amount as the price of the JSE ALSI and are viewed as having the same risk as the total market. A Beta below 1 would indicate the industry is viewed as less risky than the total market, and a Beta above 1 means as more risky or volatile than the market.
Why is this important? A high Beta means that the sector is viewed as riskier than the total market and Investors would require a higher return to compensate for their risk and would thus expect to pay relatively less for businesses in that sector.
So, what drives Beta, what makes an industry more or less risky than the total market?
There are three factors and, considering we are dealing with risk of an industry against the risk of the total market, these factors make a lot of sense. Whenever I derive the Beta for an industry I do a high-level sense check, by considering these factors, to make sure my Beta, and in turn my business valuation is reasonable.
These factors are business risk, operating risk, and financial leverage.
Business risk is driven by the level of discretionary vs non-discretionary spend in that industry. For example, if the economy hits a downturn non-discretionary spend, like food, will not be as severely affected as the white goods industry where purchase can be delayed, making the food industry less risky and justifying a lower Beta.
Operating risk is determined by the amount of operating leverage. In simple terms, the operating leverage is the amount of fixed cost relative to total cost. The higher the fixed cost the higher the leverage the higher the risk and the higher the Beta. A good example would be the retail sector which has a high variable cost in terms of cost of sale and a relatively lower fixed cost base vs for example the airline industry which has higher fixed costs and higher operating leverage.
The final factor, financial leverage, is the risk associated with using debt. The higher the debt the higher the risk and the higher the Beta. When calculating Beta, it is simple to remove the impact of debt, a subject for another day.
The beauty of the “hack” is the ability to check the reasonability of the final Beta by looking at 3 easy to determine factors. I don’t want to be hung out to dry by other business valuation experts but in certain circumstances one could even determine a Beta based on these factors if the purpose of the business valuations wasn’t too mission critical.
Agilequity specialises in valuing businesses. If you would like to know more about our business valuation services, please visit our website www.agilequity.co.za and we would be happy to have a free half an hour consultation about your Business Valuation.