Differences in Estimation of Equity Betas

Note that significant differences can exist among beta estimates for the same stock
published by different financial reporting services. One of the implications of this is that a
valuation analyst should try to use betas for guideline companies used in a valuation from
the same source. While we recommend that valuation analysts calculate their own beta
estimates, if you are not calculating beta yourself, and if the betas for all of the selected
guideline companies are not available from a single source, the best solution probably
may be to use the source providing betas for the greatest number of guideline companies,
and not use betas from other sources for the others. This helps to avoid “an apples-and-
oranges” mixture of betas calculated using different methodologies. Differences in the
beta measurement derive primarily from choices within four variables:

1. The length of the time period over which the historical returns are
measured (i.e., the length of the look-back period)

2. The periodicity (frequency) of return measurement within that time

period (e.g., weekly versus monthly, etc.)

3. The risk-free rate above which the excess returns are measured

4. The choice of which index to use as a market proxy

The length of time period over which the historical returns are measured can have
significant impact on the beta estimate. If a fundamental change in the business
environment in which an individual company (or even an industry) operates occurs, the
valuation analyst should consider whether using historical data from before the change
should be included in the overall analysis.

A simple example of this concept is provided. A rolling 60-month beta is shown for the
Financials sector over the time period January 2007–December 2019, a period which
includes the 2008 Financial Crisis. Clearly something fundamentally changed in the
Financials sector post-crisis (see area of heightened beta values in the middle of the
graph). In mid-2014 the heightened beta values of the Financial sector returned to the
lower values similar to those seen in pre-crisis, likely primarily due to the months most
deeply affected by the 2008 Financial Crises dropping out of the 60-month rolling beta
calculation.

An analyst assessing Financial sector betas as of, say, December 31, 2019 has to decide
if the information embedded in the post-crisis returns through mid-2014 is still pertinent.
If not, then the valuation analyst should consider shortening the lookback period over
which the beta is calculated to exclude the post-crisis returns information.

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 1.6
Pre-
1.5 Financial
Crisis
1.4

1.3

1.2
Beta

1.1 Post-Financial Crisis

1.0

0.9
60-month Rolling Beta of
0.8 Financial Sector
Mid-2014 and Forward
0.7

0.6

Source of underlying data: (i) Standard & Poor’s Capital IQ database (ii) Morningstar, Inc. The financials sector is represented by
the S&P Composite 1500 Financials Index. The S&P Composite 1500 Financial Index ® are comprised of members of the GICS®
financial sector. Used with permission. All rights reserved. Calculations by Duff & Phelps, LLC.

The overall goal is to look for the best beta estimate, reflecting the expected risk of the
guideline companies, and ideally derived using the same data sets, methodologies, and
time periods.

Tendency Toward Market or Industry Average

One technique used by Bloomberg and Value Line for adjusting historical betas weights
the historical beta estimate by approximately two-thirds, and the market beta of 1.0 by
approximately one-third. This adjustment is sometimes referred to as the “Blume”
adjustment, or the “one third/two thirds” adjustment.1 This is a mechanical “one size fits
all” adjustment that has the net effect of adjusting historical betas that are less than 1.0
upward, and adjusting historical betas that are greater than 1.0 downward. The
adjustment is said to create a “forward” (or prospective) estimated beta because this
adjustment is based on the assumption that betas tend to move toward the market’s beta
(1.0) over time. It does not indicate that any adjustment to the data used in calculating the
historical beta estimate was made.

Another technique for adjusting beta estimates is a more sophisticated technique called
Vasicek shrinkage.2 The general idea is that betas with the highest statistical standard

1
Blume, M.E., “On the Assessment of Risk”, Journal of Finance, Vol. 26, 1971, pp.1–10. This adjustment is sometimes referred to
as the “Blume” adjustment, or the “one third/two thirds” adjustment. The equation for this adjustment is Betaadjusted = 0.371 +
0.635Betahistorical.
2
The formula was first suggested by Oldrich A. Vasicek, “A Note on Using Cross-Sectional Information in Bayesian Estimation of
Security Betas”, Journal of Finance (1973).

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errors are the least reliable estimates and are, therefore, adjusted toward the market,
peer group, or industry average more than are betas with lower standard errors.3 The
Vasicek shrinkage technique is not a “one size fits all” technique like the Blume
adjustment, and also offers the flexibility to adjusting to the market, peer group, or industry
average.

The formula to calculate the Vasicek-Adjusted Beta is as follows:

σ β2i σ β2m
β Vasicek Adj = βm + βi
σ β2m + σ β2i σ β2m + σ β2i

where:
βVasicek Adj = Vasicek adjusted beta for company or portfolio i
βi = Historical beta for company or portfolio i
βm = Beta of the market industry or peer group
σ 2
βm = Variance of betas in the market industry or peer group
σ 2
βi = Square of the standard error of the historical beta for company or portfolio i

cross sectional standard error 2

weight =
( cross sectional standard error ) + ( raw beta standard error )
2 2

Vasicek AdjustedBeta = [(1- weight) xpeer groupbeta] +(weight xhistoricalbeta)

Whether betas tend to move toward market averages or industry averages over time is
an issue open to debate, although it seems more intuitive that a company in say, the
pharmaceuticals industry, will become more like the average pharmaceutical company
over time, rather than look more like the average company in any industry. In 2010’s
Global GT LP and Global GT LTD v. Golden Telecom, Inc., the Delaware Court of
Chancery wrote that “… the historic beta is considered to have a fair amount of predictive
power, and to be a reliable proxy for unobservable forward-looking betas …there is
support for the notion that more extreme betas tend to revert to the industry mean
(emphasis added) over time”. Furthermore, the Court noted that “… no reliable literature
or evidence was presented to show that the beta of a telecom company like Golden, which
operates in a risky market, will revert to 1.0”.4

3
This was the adjustment used in the Ibbotson Beta Book, where this adjusted beta was labeled Ibbotson Beta. The Ibbotson Beta
Book and the individual beta “tear” sheets previously available on the Morningstar website are no longer published.
4
Global GT LP v. Golden Telecom, Inc., 993 A.2d 497 (Del. Ch. 2010); aff'd, 11 A.3d 214 (Del 2010).

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Lag effect

For all but the largest companies, the prices of individual stocks tend to react in part to
movements in the overall market with a lag. The smaller the company, generally the
greater the lag in the price reaction. This does not necessarily imply that the market itself
is wholly inefficient, although the market for some stocks is more efficient than for other
stocks. Large-cap companies tend to be followed by more analysts and are owned by
more institutional investors than are small-cap companies. Therefore, large-cap
companies tend to react more quickly to changes in the economy or changes in the
business (e.g., introduction of a new product, signing of a new major contract) nearly
instantaneously, while smaller companies’ stocks tend to react at a slower rate.

Because of the lag in all but the largest companies’ sensitivity to movements in the overall
market, traditional OLS betas tend to understate systematic risk. A sum beta consists of
a multiple regression of a stock's current month's excess returns over the 30-day T-bill
rate on the market's current month's excess returns and on the market's previous month's
excess returns, and then a summing of the resulting coefficients. This helps to capture
more fully the lagged effect of co-movement in a company's returns with returns on the
market (market or systematic risk). Below is an exhibit showing a sampling of OLS and
sum betas for companies across the size spectrum as of December 2019.

Market Capitalization OLS Sum

Company (in $millions) Beta Beta Difference
Microsoft Corporation 1,203,062.646 1.22 1.21 -0.01
BlackRock, Inc. 78,005.519 1.54 1.59 0.05
The Bank of New York Mellon Corporation 46,414.269 1.14 1.19 0.05
FactSet Research Systems Inc. 10,180.565 0.95 1.05 0.10
Cathay General Bancorp 3,032.833 1.30 1.51 0.21
The Chefs' Warehouse, Inc. 1,156.005 0.78 1.09 0.31
REX American Resources Corporation 515.801 0.89 1.45 0.57
TSR, Inc. 7.040 1.21 1.84 0.63
Source of underlying data: (i) Standard & Poor’s Capital IQ database (ii) Morningstar, Inc. Used with permission. All rights reserved.
Betas are estimated from monthly return data in excess of the 30-day U.S. Treasury bill total return, January 2015–December 2019.
The S&P 500 Index was used as the market benchmark. Calculations performed by Duff & Phelps, LLC.

The larger the company, the smaller the difference between the OLS beta and the sum
beta tend to be, and the smaller the company, the greater the difference between the
OLS beta and the sum beta tend to be.5 The research suggests that this understatement
of systematic risk by the traditional beta measurements accounts in part, but certainly not
totally, for the fact that small-cap companies achieve excess returns over their apparent
CAPM-required returns (where the market equity risk premium is adjusted for beta).

5
Exceptions to this pattern can be found, of course, but this is the general trend in the overall population of companies.

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The formula for the Sum Beta is:

(R n - R f,n ) = α + βn × (Rm,n - Rf,n ) + βn-1 × (Rm,n-1 - Rf,n-1 ) + ε

SumBeta = βn + βn-1

where:
(Ri,n-Rf,n) = Excess return on company or portfolio i in current month
α = Regression constant
βn = Estimated market coefficient based on sensitivity to excess returns on
market portfolio in current month
(Rm,n-Rf,n) = Excess return on market portfolio in current month
βn-1 = Estimated market coefficient based on sensitivity to last month's excess
returns on market portfolio
(Rm,n-1-Rf,n-1) = Excess return on market portfolio last month
ε = Regression error term

Sum betas for individual stocks can be calculated using a spreadsheet such as Microsoft
Excel and historical return data, which is available from several sources (e.g., Standard
& Poor's Capital IQ). Some analysts prefer to calculate their own sum betas for a peer
group of public companies (which they use as a proxy for the beta of their subject private
business in the context of CAPM) and thus make a smaller adjustment for the size effect.
The theory is that the sum beta helps correct for the larger size effect that is principally
due to a misspecification of beta when using traditional OLS betas for smaller companies.
It should be noted that sum beta estimates may at times be statistically “noisy”. When
estimating a proxy beta using any look back method, valuation analysts should always be
cautious when dealing with a small number of guideline companies.

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