I don’t have a clear understanding of levered and unlevered beta and it would be great if someone could help me.
Correct me if I am wrong, when we unlever beta, we remove the debt component. The Schweser book says “The unlevering process isolates systematic risk”. But, beta already represents the systematic risk, so why do we have to unlever it in the first place?
Also, why do comparable firms have equal unlevered beta but not levered beta?
Thanks.
isolates systematic risk (Leaves behind risk due to the equity component) by removing any effect of debt (leverage)
one the two firms are full equity ONLY companies - they are equal unlevered beta.
Sure!
Yes.
It means you erase specific risk (unsystematic risk) and get the systematic risk only.
Beta represents systematic risk, and it is widely stated that assets with similar characteristics should have similar risk and return. A certain unlevered beta represents a specific asset class and type, that’s why firms in the same industry and region should have the same unlevered beta. When you lever it using the capital structure of each company, they will all differ from the others.
Hope this helps!
Thank you very much for the clear explanations!
Let us first understand the origin of Beta.
Beta actually comes from regressing the returns on the stock against the stock in the market. The slope of the line is the Beta.However this beta is Levered Beta and the leverage implicit in the beta estimate is the average market debt equity ratio during the period of the regression
Once you unlever it, the unlevered Beta implies beta of being in that business/industry. So an unlevered beta of a pharmaceutial company reflects beta of being in pharma industry and hence all comparables will have same unlevered Beta. However, based on the debt the company has, the levered beta will then change