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Valuation & Betas (CAPM)

Blog: Valuation & Betas (CAPM)


From June until August 2019 I have written 6 blogs on business valuation and financial modelling in order to calculate enterprise value. These blogs are still available, you can find the links of the blogs on the very end of this blog.


In the upcoming months, I will write several blogs on the so called “Cost of Capital” that is used in business valuation.


The Cost of Capital is critical to understand and in this first blog in the sequence I will talk about the “risk free rate” and “betas”.


I am an independent M&A consultant and Valuator from The Netherlands.


In addition, I provide training in “Financial Modelling”, “Business Valuation” and “Mergers & Acquisitions” all over the world. This at (investment) banks, corporates and universities.


Introduction to the “Capital Assets Pricing Model” (CAPM)


An equity investor can eliminate his or her exposure to specific risk by holding a portfolio of many different equity investments.


These equity investors only bear to called “systematic risk”, because “specific risk” of companies can be diversified away by holding stakes in different companies.


The most commonly used model for assessing “systematic risk”, and calculating the “cost of equity capital”, is the “Capital Asset Pricing Model” (CAPM).


The formula of the CAPM goes as follows:


Cost of equity (Ke) = risk free rate (Rf) + equity beta of investment (Be) * Equity market risk premium (EMRP).


In this blog I will shortly discuss the Rf and the Be extensively. The next blog after this one is purely devoted to the EMRP.


Risk free rate


The first component of the CAPM is the risk free rate. This represents the return an investor can achieve on the least risky asset in the market.


Ordinary government bonds are the securities used by most valuation practitioners when estimating the cost of capital.


Most cost of capital and valuation work is conducted in nominal terms (not corrected to “real terms” for inflation) and ordinary governments bonds provide a ready measure of the nominal risk free rate.


The maturity for the risk free instrument should match the profile of the cash flows in question.


With my own valuations in The Netherlands I use 10 year government bonds, but I will get back to this later on in this sequence of blogs on the “cost of capital”.


Introduction to Betas


The second component of the CAPM is the beta, or more precisely the equity beta.


You can find the component below in the CAPM formula:


Cost of equity (Ke) = risk free rate (Rf) + equity beta of investment (Be) * Equity market risk premium (EMRP).


The beta is the factor in the CAPM by which the EMRP is multiplied in order to reflect the risk associated with a particular equity investment.


The EMRP is discussed in the blog after this one, and I will now zoom in further on the beta.


Beta and risk


Shareholders face two types of risk: Market (or systematic) risk and specific risk.


Specific risks are associated with events affecting cash flows that are specific to the company in question.


Market risks on the other hand are risks correlated with the stock market or general economy, such as the possibility of a rise in interest rates.


Equity investors do not need to bear specific risks, which due to their random nature, offset each other (you win some you lose some), and can be eliminated by holding a portfolio of diversified investments (this is “modern portfolio theory”).


Market risks on the other hand can not be eliminated by diversification.


They represent the fundamental risks that shareholders have to bear, because they affect all stocks to a greater or lesser extent. And it is this level of market risk that beta seeks to measure.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Calculating beta


In practice the best way to estimate the beta of a firm is to calculate the historical covariance between the returns on the firm’s equity and the returns from the stock market as a whole. And then use this as a proxy for the future beta.


The formula is: Equity beta (Be) = Covariance between returns on a certain stock and the returns on the market index / Variance of the market index.


To derive beta a least squares regression is performed, measuring the observed historic relationship between the change in a company’s share price, plus the dividend income received (or without dividend), and the change in the value of the stock market.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Reasons for different values in betas


The average equity beta in the market must be one. But firms that expose their equity investors to greater systematic risks than the average firm in the market have betas in excess of one.


And those that expose their equity investors to lower systematic risks have betas below one.


A number of factors drive betas, these include:

1. Cyclicality of revenues;

2. Operational leverage;

3. Financial leverage.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Beta driver 1: Cyclicality of revenues


Beta measures the historic observed correlation of changes in the returns on a firm’s equity with changes in the returns on the market as a whole.


While intuitively beta is associated with the overall volatility of a business, as measured by the volatility of earnings, this is not what beta actually measures.


If much of the overall volatility of a business is not correlated with the market as a whole, then beta will not be large.


This is as it should be since much of this volatility may be diversifiable at the level of the investor’s portfolio, and beta only measures volatility that is undiversifiable.


What really matters to equity investors who hold portfolios of equities is the degree to which a company’s cash flows are affected by factors systemic to all companies.


So for example: Changes in GDP, interest rates, inflation etc.

And this is what betas show.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Beta driver 2: Operational leverage


Operational leverage is defined as the level of fixed costs in relation to the total costs of a company.


And this level has an impact on the systematic (market) risk to which equity investors in a firm are exposed.


Fixed costs magnify the effect of underlying systematic risk.


Because if revenues were to fall due to systematic (market) factors, then the fixed costs of the firm would still have to be met out of the cash generated.


Variable costs would effectively provide a cushion to revenue cyclicality, whereas fixed costs “gear up” revenue cyclicality, and increase the systematic (market) risk of the free cash flows.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Beta driver 3: Financial leverage


Financial leverage also “gears up” the systematic (market) risk of the free cash flows (to equity providers).


This because debt service payments do not vary with the state of revenues and have to be met out of cash generated.


This is referred to as “financial risk” as opposed to “operational risk”.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Equity and asset betas


Betas provided by data-providers such as DataStream and Bloomberg are derived directly from historical market information on equities and are therefore known as equity betas.


These betas take into account the effects of financial leverage and operational risk.


Asset betas on the other hand are generally unobservable. They reflect only the operational risk of the underlying business assets. And these assets betas have to be calculated from equity betas by adjusting the gearing of the company in question.


So just to wrap up: Equity betas do include operational and financial risk. And asset betas only include operational risk.


The formula to calculate asset betas is as follows:

Asset Beta (Ba) or unlevered beta = equity beta (Be) / ( 1 + market value of debt (D)/ market value of equity (E)).

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


The difficulties in measuring Betas


Historic beta estimation presents some challenges like for example:


1. Over what period should we measure beta;

2. Frequency and number of observations used;

3. Is comparator or sector analysis useful.


Measuring Betas 1: Choice of period for measurement


It is desirable to have as many observations as possible in order to maximize confidence in the statistical reliability of the beta measured. This is measured by the standard error of the beta, the lower the standard error of the beta, the greater the confidence one can have in the estimate.


On the other hand it is important to recognize that corporate risk profiles can significantly change over the years.


In practice this trade-off is best solved by selecting a period that is long enough to capture sufficient observations to minimize standard errors, but not so long that it is likely that the corporate risk profile will have changed fundamentally.


It is common to use 5 years as a default duration.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Measuring Betas 2: Frequency and number of observations used


Five years of stock market information is typically considered appropriate for the purpose of beta estimation.


But should the share price and stock market index information used in the regressions be monthly, weekly or daily?


Generally speaking, regressions using monthly information have lower standard errors than regressions using either weekly or daily data.


This probably because monthly observations are less likely to suffer from “noise” in comparison to weekly or daily observations.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Measuring Betas 3: Comparator analysis, finding a peer


A practical solution to the problems of errors in beta estimation is provided by analysis of comparable companies.


This is also a very useful and practical technique for estimating betas for companies that are not listed on the stock market !! 😊


For comparator work it is needed to strip out the effects of different levels of leverage. Only this way one can make a true comparison


This because different business in the same sector can have different levels of leverage, so equity betas need to be converted to assets betas (unlevered betas).


Asset betas (or unlevered betas) can be calculated with the formula mentioned above.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)


Next blog next week


In hope you liked this introduction on Betas and CAPM. 😊


In my next blog, next week, I will talk about the “Equity market risk premium” (EMRP).


And when you have any questions in the mean time do not hesitate to contact me on:


Sources used for this blog

· The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.

This book is fantastic and very practical, just a pleasure to read for every investment professional. Highly recommended! 😊


Training Calendar on Business Valuation of Joris Kersten:


In case you like additional in class training:

In my home country The Netherlands, and abroad, I provide open training programs in “Business Valuation” and “Financial Modelling”.


The next sessions are given below:


1. Business Valuation & Deal Structuring (6 day training): 18, 19, 20, 21 and 23, 24 March 2020 @ Uden in the South of The Netherlands;

2. Financial Modelling in Excel (4 day training): 20, 21, 22, 23 April 2020 @ Uden in the South of The Netherlands;

3. Financial Modelling in Excel (5 day training): 2, 3, 4, 5, 6 February 2020 @ Riyadh in Saudi Arabia.

All info on these open training sessions can be found on:

And 130 references on my training sessions can be found on:


Trainer & Consultant: J.J.P. (Joris) Kersten, MSc BSc RAB


· 130 recommendations on his training can be found on:

· His full profile can be found on:


J.J.P. (Joris) Kersten MSc BSc RAB (1980) is owner of “Kersten Corporate Finance” in The Netherlands, under which he works as an independent consultant in Mergers & Acquisitions (M&A’s) of medium sized companies.


Joris performs business valuations, prepares pitch books, searches and selects candidate buyers and/ or sellers, organises financing for takeovers and negotiates M&A transactions in a LOI and later in a share purchase agreement (in cooperation with (tax) lawyers).


Moreover, Joris is associated to ‘AMT Training London’ for which he provides training as a trainer and assistant-trainer in Corporate Finance/ Financial Modelling at leading investment banks in New York, London and Hong Kong.


And Joris is associated to the ‘Leoron Institute Dubai’ for which he provides finance training at leading investment banks and institutions in the Arab States of the Gulf.


In addition, Joris provides lecturing in Corporate Finance & Accounting at leading Universities like: Nyenrode University Breukelen, TIAS Business School Utrecht, the Maastricht School of Management (MSM), the Luxembourg School of Business and SP Jain School of Global Management in Sydney.


Moreover, he provides lecturing at partner Universities of MSM in: Peru, Surinam and Mongolia. And at partner Universities of SP Jain in Dubai, Mumbai and Singapore.


Joris graduated in MSc Strategic Management and BSc Business Studies, both from Tilburg University. In addition, he is (cum laude) graduated as “Registered Advisor Business Acquisitions” (RAB), a 1-year study in the legal and tax aspects of M&A’s. And Joris obtained a degree in “didactic skills” (Basic Qualification Education) in order to lecture at Universities.


Currently Joris is doing the “Executive Master of Business Valuation” to obtain his title as “Registered Valuator” (RV) given out by the “Netherlands Institute for Registered Valuators” (NIRV). This title will enable Joris to give out business valuation judgements in for example court cases.


J.J.P. (Joris) Kersten, MSc BSc RAB. Email: Phone: +31 6 8364 0527


Earlier blogs on “Business valuation to Enterprise Value”


From June until August I have written the following blogs on valuation:


1. Leveraged Buyout Analysis (LBOs);


2. M&A Analysis” (M&A model – Accretion/ Dilution);


3. Discounted Cash Flow Valuation (DCF);


4. Valuation Multiples 1 – Comparable Companies Analysis (comps);


5. Excel Shortcuts & Business Valuation;


6. Valuation Multiples 2 – Precedent Transaction Analysis.


You can find them on the links below:


1) LBO Analysis (June 9th 2019):


2) M&A Analysis (June 20th 2019):


3) Discounted Cash Flow Valuation (July 24th 2019):


4) Valuation Multiples 1 – Comparable Companies Analysis (August 26th 2019):


5) Excel Shortcuts & Business Valuation (August 28th 2019):


6) Valuation Multiples 2 – Precedent Transaction Analysis (August 19th 2019):


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