Bottom-up beta estimation

What is a bottom-up beta?

A bottom-up beta is estimated by starting with the businesses that a firm is
in, estimating the fundamental risk or beta of each of these businesses
and taking a weighted average of these risks.

Beta of Equity

Beta of Firm Financial

Leverage

Nature of product or Operating leverage Implications:

service
Implications:
1. Cyclical companies have higher
betas
2. Luxury goods firms have higher
beta
3. High priced product service
firms have higher beta
4. Growth firms have higher beta
(%fixed costs in total cost) 1. Highly levered firms on
average have higher
equity beta
Implications:
1. Firms with high
infrastructure needs and
rigid cost structure have
higher betas
2. Smaller firms have higher
betas
 Bottom-up beta
Beta of a firm = weighted average of the betas of all the different business

Steps involved in estimating bottom-up betas:

1. Break your company down into the businesses that it operates in. Do
not define your business too narrowly or you will run into trouble in
step 2.
2. Estimate the risk (beta) of being in each business. This beta is called an
asset beta or an unlevered beta.
3. Take a weighted average of the unlevered betas of the businesses you
are in, weighted by how much value you get from each business.
4. Adjust the beta for your company's financial leverage (Debt to equity
ratio)
 Comparable companies
• Narrow version of comparable firm is another firm in the same business that
your firm is in.
• The broader definition of comparable firm includes any firm whose fortunes are
tied to your firm's success and failure (or vice versa).
• Define "comparable firm" narrowly as a firm that is very similar to your firm.
(Thus, if your firm makes entertainment software, look for other firms that are
entertainment software firms as well.) If you get a large enough sample (see
answer to question 4), stop.
• If not, try expanding your sample, using any or all of the following tactics:
1. Define comparable more broadly (all software as opposed to entertainment
software).
2. Look for global listings of companies in the same business; all entertainment
companies listed globally would be an example.
3. Look up and down the supply chain for other companies that feed into your
company and that your company feeds into. Thus, you may start looking for
software retailers that get the bulk of their revenues from entertainment
software.
 Sample of companies
How big a sample of firms do we need?

• Any sample size greater than one is an improvement on a regression beta.

However, the more firms that you have in your sample, the greater the
potential savings in error.
• With a sample of 4, your standard error will be cut by half;
• With a sample of 9, by two-thirds;
• With a sample of 16, by 75%.
• Try to get to double digits for your sample size, if you can. If you cannot, settle
for 6-8 firms and you are still saving a substantial amount in terms of estimation
error.
There is clearly a trade-off between how tightly you define "comparable firm" and
your sample size. If you define comparable narrowly (firms like just like yours in
terms of size and what they do), you will get a smaller sample. If you can get to
double digits with a narrow definition, stay with it. If your sample size is too small,
try one of the techniques suggested in the answer to question 3 to expand your
sample.
 Unlevered asset beta
Once we have comparable firms, how do we estimate the unlevered (asset) betas?

1. Do the regression betas for the comparable firms all have to be over the same
time period and against the same index?
In a perfect world, yes.! However, as your sample size increases, you can afford to
get sloppy with these details, hoping that the law of large numbers bails you out.
Thus, if you have 100 global firms in your sample, with betas estimated against local
indices, you can get away using an average of these 100 betas since some are likely
to be overestimated and some underestimated.

2. Once we have the regression betas for the firms, should we use simple or
weighted averages?
Use simple averages. Otherwise, you will be attaching the beta of the largest firm or
firms in your group to all of the firms in the sample. Microsoft's beta will become
every software company's beta.
 Unlevered asset beta
3. Why do we need to correct for financial leverage?
Your company can have a very different policy on how much debt to use than the
typical firm in the sample. Regression betas are levered betas but they reflect the
financial leverage of the companies in the sample (and not your company). You have
to take out the financial leverage effect (unlever the beta) to come up with a pure
play or business beta.

𝑅𝑒𝑔𝑟𝑒𝑠𝑠𝑖𝑜𝑛 𝑏𝑒𝑡𝑎
𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎 = 𝐷
൙
1 + 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 𝐸

4. Should we unlever each firm's beta and then average or average and then
unlever?
Individual firm regression betas are noisy (have large standard error) and unlevering
them only compounds the noise. Averaging first should reduce the noise, leading to
better beta estimates.
 Unlevered asset beta
5. What tax rate and debt to equity ratio should I use for the sector?
To be safe, go with a marginal tax rate and use either the median D/E ratio
or the aggregate D/E ratio for the sector. (There are always strange outliers
with D/E ratios that make simple averages go haywire.)

6. Why do I need to adjust for cash and how do I do it?

The regression beta for a company reflects all of its assets (including cash).
Thus, if a firm is 60% software and 40% cash, its regression beta will be
lower because cash is riskless. Since we want a pure software business beta,
we should be cleaning up the betas for cash holdings.
If we assume that cash has a beta of zero, this adjustment is trivial:

𝐶𝑎𝑠ℎ 𝑎𝑑𝑗𝑢𝑠𝑡𝑒𝑑 𝑏𝑒𝑡𝑎 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎൘ 𝐶𝑎𝑠ℎ

1−
𝐹𝑖𝑟𝑚 𝑉𝑎𝑙𝑢𝑒
Firm value = Market value of Equity + Market value of Debt
 Operating leverage
Is it possible to adjust these unlevered betas for operating leverage?
It is possible, but only if you know what costs are fixed and what are
variable not only for your firm but for all of the firms in your sample. If you
do have that information, you can break the unlevered beta down into a
business component (reflecting the elasticity of demand for your company)
and an operating leverage component:

𝐵𝑢𝑠𝑖𝑛𝑒𝑠𝑠 𝑅𝑖𝑠𝑘 𝑏𝑒𝑡𝑎 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎൘ 𝐹𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠

1+
𝑉𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠

The problem from a practical standpoint is getting the fixed and variable
cost breakdown.
 Weighting of businesses
How do we weight these unlevered betas to arrive at the beta for the company?

The weights should be market value weights of the individual businesses that the
firm operates in.
However, these businesses do not trade and you have to estimate the market values.
You can use weight based on revenues or earnings from each business but you are
assuming that a dollar in revenues (earnings) has the same value in every business.

An alternative is to apply a multiple of revenues (earnings) to the revenues

(earnings) from each business to arrive at an estimated value.
This multiple can be estimated for the comparable firms (from which you estimated
the betas).
Since you are interested in the value of the business (and not the value of equity),
you should look at EV multiples (and not equity multiples).
If you use revenues, use an EV/ Sales multiple.
 Finanical Leverage
How do we adjust for financial leverage?

The standard adjustment for financial leverage is to assume that debt has no market
risk (a beta of zero) and to use what is called the "Hamada" adjustment:
𝐷𝑒𝑏𝑡
𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎 1 + 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒
𝐸𝑞𝑢𝑖𝑡𝑦
You can use the current debt to equity ratio for the firm you are analyzing or even a
target debt to equity (if you feel that change is on the horizon) in making this
computation.

If you feel uncomfortable about the assumption that debt has no market risk,
estimate a beta for debt and compute the levered beta as follows:

𝐷 𝐷
𝐿𝑒𝑣𝑒𝑟𝑒𝑑 𝐵𝑒𝑡𝑎 = 𝑈𝑛𝑙𝑒𝑣𝑒𝑟𝑒𝑑 𝑏𝑒𝑡𝑎 1 + 1 − 𝑡𝑎𝑥 𝑟𝑎𝑡𝑒 − 𝐵𝑒𝑡𝑎 𝑜𝑓 𝐷𝑒𝑏𝑡 1 − 𝑡
𝐸 𝐸
The tricky part is estimating the beta of debt.
 Change in the beta
Can bottom-up betas change over time for a company?

Yes, and for two reasons:

1. One is that the mix of businesses can change over time, leading to a
different unlevered beta.

2. The other is that the debt to equity ratio for the firm can change over
time, leading to changes in the levered beta.
 Beta comparison
Why is a bottom-up beta better than a regression beta?

Bottom-up betas are better than a regression beta for three reasons:
1. They are more precise. The standard error in a bottom-up beta
estimate is more precise because you are averaging across regression
betas.
The savings will approximate 1/ Square root of number of firms in the
sample. Thus, even if your firm is only one business and has not
changed its debt-to-equity ratio over time, you will be better off using
bottom-up betas.
2. If a firm has changed its business mix, you can reflect that more easily
in a bottom-up beta because you set the weights on the different
businesses. A regression beta reflects past business mix choices.
3. If a firm has changed its debt-to-equity ratio, the bottom-up beta can
be easily adjusted to reflect those changes. A regression beta reflects
past debt-to-equity choices.
 Disney example
• Disney is an entertainment firm with diverse holding

1. Studio entertainment
2. Media networks
3. Park resorts
4. Consumer products
5. Others: Cruise lines, internet operations, sports franchises
 Disney example
• Identify comparables

Unlevered Beta
Average Cash/Firm Corrected for
Business Comparable Firms # of Firms Levered Beta Median D/E(%) Unlevered Beta Value (%) Cash

Radio and TV
Media broadcasting
networks companies 24 1,22 20,45 1,0768 0,75 1,085

Parks and Theme parks and

Resorts entertainment firms 9 1,58 120,76 0,8853 2,77 0,9105

Studio
entertainment Movie companies 11 1,16 27,96 0,9824 14,08 1,1435

Toy and apparel

retailers;
Consumer Entertainment
products software 77 1,06 9,18 0,9981 12,08 1,1353
 Disney example
• Weighted average of each business

Estimated Value Firm Value Proportion

Business Revenues ($m) EV/ Sales ($m) (%) Unlevered Beta

Media networks 10941 3,41 37278,62 49,25 1,085

Parks and Resorts 6412 2,37 15208,37 20,09 0,9105

Studio
Entertainment 7364 2,63 19390,14 25,62 1,1435

Consumer
products 2344 1,63 3814,38 5,04 1,1353

Disney 27,061 -- 75691,51 100 1,0674

 Disney example
• Marginal tax rate 37,3%
• Market value of equity $55.101m
• Estimated market value of debt $14.668m

14668
𝐸𝑞𝑢𝑖𝑡𝑦 𝑏𝑒𝑡𝑎 = 1,0674 1 + 1 − 0,373 = 1,2456
55101