Does CAPM Use Levered or Unlevered Beta?

The Capital Asset Pricing Model (CAPM) and beta are foundational elements in financial analysis, used for evaluating investment risk and determining expected returns. CAPM estimates the expected return an asset should generate, given its exposure to market risk. Beta quantifies an asset’s systematic risk, which cannot be eliminated through diversification. Understanding the distinction between levered and unlevered beta and their application within CAPM is essential for accurately assessing investment opportunities.

Understanding Beta

Beta quantifies a security’s sensitivity to overall market movements. It captures systematic risk, representing inherent risks affecting the entire market or economy, such as interest rate changes or geopolitical events. This type of risk is non-diversifiable, meaning it cannot be mitigated by adding more assets to a portfolio.

Interpreting beta values provides insight into an asset’s market sensitivity. A beta of 1.0 indicates the security’s price volatility mirrors that of the broader market. If the market moves up or down by 1%, the security is expected to move by 1% on average. A beta greater than 1.0 suggests the security is more volatile than the market, implying larger price swings. Conversely, a beta less than 1.0 signifies less volatility, indicating the security’s price is more stable relative to the market.

Levered beta, or equity beta, measures the volatility of a company’s stock price relative to the market, considering both its business risk and financial risk from debt. This beta reflects the risk borne by equity holders, as debt amplifies the volatility of equity returns. Financial data providers typically quote levered beta, making it the readily available figure for publicly traded companies.

Unlevered beta, also known as asset beta, isolates a company’s business risk by removing the effects of its capital structure. It represents the volatility of a company’s assets as if the company had no debt financing. This measure is useful for comparing the inherent business risk of companies with differing levels of financial leverage.

The relationship between levered and unlevered beta highlights how financial leverage increases a company’s equity risk. When a company takes on more debt, it increases the financial risk to its equity holders, leading to a higher levered beta compared to its unlevered beta. If a company has no debt, its levered and unlevered betas would be identical, as there is no financial risk component.

The Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM) is a financial model used to determine the expected return on an investment or a company’s cost of equity. It establishes a linear relationship between the required return on an investment and its systematic risk. The model helps investors assess whether the potential return of a risky asset adequately compensates for its risk.

The basic CAPM formula is: Expected Return = Risk-Free Rate + Beta \ (Market Return – Risk-Free Rate). The risk-free rate represents the theoretical return on an investment with zero risk, typically proxied by the yield on a U.S. Treasury bond.

The market return is the expected return of the overall market, often represented by a broad market index like the S&P 500. The difference between the market return and the risk-free rate is the market risk premium, quantifying the additional return investors expect for market risk.

Beta, within the CAPM formula, measures how sensitive an asset’s returns are to changes in the overall market. It links the asset’s specific risk profile to the broader market’s risk and return characteristics. The specific type of beta used is crucial for accurate application.

The CAPM operates under assumptions like rational investors and efficient markets. Despite these theoretical simplifications, the model remains a practical and widely used tool for linking risk and expected return in investment valuation.

Applying Levered Beta in CAPM

For calculating a company’s cost of equity using the Capital Asset Pricing Model, levered beta is the direct and appropriate input. CAPM’s primary function in this context is to determine the required rate of return for equity investors. Equity investors bear the full financial risk of a company, which explicitly includes the impact of debt financing.

Levered beta inherently incorporates this financial risk, as it reflects the volatility of a company’s stock price given its existing debt levels. When debt is present in a company’s capital structure, it amplifies the fluctuations in earnings available to equity holders, thereby increasing the risk associated with their investment. Therefore, using levered beta ensures that the calculated cost of equity accurately represents the total risk that equity investors assume.

Unlevered beta, while not a direct input for calculating the cost of equity in CAPM, serves as an important analytical tool in specific financial scenarios. It is primarily used to facilitate comparability between companies with different capital structures. For instance, when valuing private companies or analyzing public companies with unique debt-to-equity ratios, analysts often need to adjust for these differences.

The process involves “unlevering” the beta of comparable public companies to strip out the effect of their individual debt levels, thereby isolating their pure business risk. Once the unlevered betas of comparable firms are obtained, they can then be “re-levered” using the target company’s specific capital structure. This re-levering process produces an appropriate levered beta that accurately reflects the target company’s financial risk, which is then used in the CAPM formula.

Ultimately, while unlevered beta is a crucial intermediate step for analytical rigor and comparability, the final beta input into the CAPM formula for determining the cost of equity is always the levered beta. This ensures the model accurately captures the comprehensive risk faced by equity holders.