Levered vs Unlevered Beta
Since levered beta and unlevered beta are both measures of volatility used to analyze the risk in investment portfolios, in financial analysis, it is necessary to know the difference between levered and unlevered beta to decide which measure to use in your analysis. Beta measures systematic risk that cannot be diversified away. Beta shows the sensitivity of a fund’s, security‘s or portfolio’s performance in relation to the market as a whole. Beta is a relative measure, used for comparison and does not show a security’s individual behavior. Beta allows the investor to determine a stock’s performance in comparison to the entire market’s performance. There are two types of beta measures; levered and unlevered beta. The following article takes a closer look at both and highlights the similarities and differences between levered and unlevered beta.
What is Levered Beta?
Levered beta measures the sensitivity of a security’s or portfolio’s tendency to perform in line with the market or against the market. Levered beta includes the company’s debts in the calculation. A levered beta with a positive value shows that the security’s value will perform with the market and a levered beta with a negative value means that the security’s value will perform against the market. A levered beta of zero shows that the security has no correlation to the market. Levered beta takes into consideration the company’s debt, which generally results in a beta value closer to zero (showing lower volatility) due to tax advantages. Determining a stock’s levered beta helps the investor to decide and determine the correct course of action to be taken in order to improve profitability. When the security’s performance is in line with the market, the investor should invest when the market is performing well. When the security’s performance is against the market, it is better for the investor to invest when the market performance is poor.
What is Unlevered Beta?
Unlevered beta also measures a security’s performance in relation to market movements. However, unlike beta calculation, unlevered beta calculates the risk of a company that has no debt against the risk of the market. Unlevered beta calculation removes the debt factor when arriving at the beta figure. As the effect of leverage is removed from the calculation beta figure derived is said to be more accurate. Unlevered beta is calculated by the formula:
Unlevered Beta = BL / [1 + (1 – TC) × (D/E)]
The company’s levered beta is divided by [1 + (1 – TC) × (D/E)] to obtain the unlevered beta. Here, BL denotes the levered beta, TC denotes the tax rate, and D/E is the debt to equity ratio of the company.
What is the difference between Levered and Unlevered Beta?
Beta is an important metric in financial management that offers investors an idea of a stock’s volatility against the market. Beta measures systematic risk which is prevalent in the entire marketplace, economy and industry and cannot be diversified away. Calculation of the beta value offers investors additional information necessary to make investment decisions. Two types of beta include levered and unlevered beta. Levered beta takes into account the company’s debt, whereas unlevered beta does not take into account debt held by the firm. Of the two, levered beta is said to be more accurate and realistic as company debt is taken into consideration.
Summary:
Levered vs Unlevered Beta
• In financial analysis, beta is a measure of volatility used to analyze the risk in investment portfolios. Beta measures systematic risk that cannot be diversified away.
• Levered beta takes into consideration the company’s debt, which generally results in a beta value closer to zero as due to tax advantages.
• Unlevered beta also measures a security’s performance in relation to market movements. However, unlike beta calculation, unlevered beta calculates the risk of a company that has no debt against risk of the market.
• Unlevered beta is calculated by dividing the levered beta by [1 + (1 – TC) × (D/E)] to obtain the unlevered beta. Here, TC denotes the tax rate and D/E is the debt to equity ratio of the company.
• Of the two types of beta calculations, levered beta is said to be more accurate and realistic as company debt is taken into consideration.