Beta (Finance)
Beta tells you how much a stock swings relative to the market. High beta = more volatile = higher expected return required by investors.
Definition
Beta measures the systematic risk (market risk) of a stock relative to the overall market. A beta of 1.0 means the stock moves in line with the market; greater than 1.0 means more volatile; less than 1.0 means less volatile. Beta is a critical input in the CAPM formula used to calculate Cost of Equity.
Formula
Unlevered Beta = Levered Beta / (1 + (1 - Tax Rate) × (Debt / Equity))
Levered Beta
Observed beta of the stock, reflecting both business and financial risk
Unlevered Beta
Beta stripped of financial leverage — pure business/operating risk
Tax Rate
Marginal corporate tax rate (debt tax shield adjustment)
Debt / Equity
Company's debt-to-equity ratio at market values
What Beta Measures
How much a stock moves relative to the market
Scenario
Market moves +10%
Moves half as much as the market
β = 0.5
The benchmark — moves 1:1 with itself
β = 1.0
Moves nearly 2x the market
β = 1.8
Interview Tip
Beta measures systematic risk — risk that cannot be diversified away. A beta of 1.8 means 80% more volatile than the market. This directly feeds into CAPM: higher beta = higher cost of equity = lower DCF valuation.
Unlevering & Relevering Beta
Adjusting beta for different capital structures
Start: Levered Beta from Peer
Levered Beta = 1.40
This is the observed beta from a comparable company. It includes the effect of that company's capital structure (debt).
levered Beta
1.40
debt Equity
0.50
tax Rate
25%
Beta by Industry
Typical betas reflect the risk profile of each sector
Regulated, stable cash flows
Defensive, inelastic demand
The market benchmark
Growth-oriented, cyclical revenue
Binary outcomes, high uncertainty
Key Concept
Beta = 1.0 means the stock moves in lockstep with the market. Below 1.0 means less volatile (defensive), above 1.0 means more volatile (aggressive). In CAPM, higher beta directly increases the cost of equity: Ke = Rf + Beta x (Rm - Rf).
Levered vs. Unlevered Beta
Levered (equity) beta reflects both operating risk and financial risk from leverage. Unlevered (asset) beta isolates just operating risk by removing the effect of debt. In a DCF, you unlever peer betas to get pure operating risk, then re-lever at the target's capital structure using the Hamada equation. This gives you the appropriate beta for the target's CAPM calculation.
Beta in CAPM and WACC
Beta is the key variable in CAPM: Cost of Equity = Risk-Free Rate + Beta × Equity Risk Premium. A higher beta increases the cost of equity, which increases WACC, which decreases the present value of future cash flows in a DCF. This is why beta selection materially impacts valuation — small changes in beta can swing value by 10–20%. A sensitivity analysis on beta is essential in any DCF.
How to Source Beta
Raw beta is calculated by regressing a stock's returns against market returns (typically 2–5 years of weekly data). Adjusted beta (Bloomberg default) = 2/3 × Raw Beta + 1/3 × 1.0, which assumes beta reverts toward 1.0 over time. For DCF purposes, use the median unlevered beta of comparable companies rather than the target's own beta to reduce noise.
Worked Example — With Real Numbers
A peer group of 5 software companies has levered betas of 1.3, 1.1, 1.4, 1.2, and 1.5 with an average D/E of 0.3 and tax rate of 25%. Unlevered beta = 1.3 / (1 + 0.75 × 0.3) = 1.06. If your target has D/E of 0.5, re-levered beta = 1.06 × (1 + 0.75 × 0.5) = 1.46. Plugging into CAPM with Rf = 4% and ERP = 6%: Ke = 4% + 1.46 × 6% = 12.8%.
Key Takeaways
Beta measures systematic (market) risk — it cannot be diversified away
Always unlever peer betas and re-lever at the target's capital structure in a DCF
Small changes in beta materially impact Cost of Equity and therefore DCF valuation
Use median peer unlevered beta rather than the target's own beta for stability
Common Mistakes in Interviews
Using levered beta directly from Bloomberg without unlevering and re-levering
Confusing raw beta with adjusted beta — Bloomberg reports adjusted by default
Using a 1-year regression period, which introduces too much noise
How Interviewers Test This
Know the Hamada equation cold: unlever peer betas, take the median, re-lever at the target's D/E. If asked 'what beta would you use for a private company?', explain the peer unlever/re-lever process. Test your understanding with the IB Quiz.
Related Concepts
Directly referenced in this topic
Cost of Equity
The cost of equity is the rate of return that equity investors require to compen...
Weighted Average Cost of Capital (WACC)
The Weighted Average Cost of Capital (WACC) is the average rate of return a comp...
Equity Risk Premium (ERP)
The equity risk premium (ERP) is the incremental return investors expect from in...
Capital Structure
Capital structure refers to the specific mix of debt and equity a company uses t...
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