How debt affects a company's beta depends on which type of beta (a measure of risk) you mean. Debt affects a company's levered beta in that increasing the total amount of a company's debt will increase the value of its levered beta. Debt does not affect a company's unlevered beta, which by its nature does not take debt or its effects into account. In this article, we'll review the difference between levered and unlevered beta, along with how a company's debt level impacts its beta.

Key Takeaways

  • A company's debt level impacts its beta, which is a calculation investors use to measure the volatility of a security or portfolio.
  • Because unlevered beta removes debt from the equation, the amount of debt a company has does not impact unlevered beta.
  • In contrast, the calculation for beta (also known as levered beta or equity beta) includes the impact debt has on the volatility of a company's stock.
  • If a company increases its debt to the point where its levered beta is greater than 1, the company's stock is more volatile than the market.
  • If a company decreases its debt to the point where its levered beta is less than 1, the company's stock is less volatile than the market.

Levered Beta vs. Unlevered Beta

Beta is a calculation investors use to measure the volatility of a security or a portfolio compared to the market as a whole. Beta measures systematic risk, which is the risk inherent to the market or market segment. Investors use a stock's beta to estimate how much risk the stock might potentially add or subtract from a diversified portfolio.

Beta is also referred to as levered beta or equity beta. When evaluating a company's risk, both debt and equity are factored into the equation to calculate beta. Unlevered beta removes debt from the equation in order to measure the risk due solely to a company's assets.

How to Calculate Levered Beta

The equation for a company's levered beta is as follows:

Beta levered=Beta unlevered(1+(1tax rate)DebtEquity)\text{Beta levered} = \text{Beta unlevered}*\left( 1 + \frac{\left( 1-\text{tax rate} \right )*\text{Debt}}{\text{Equity}} \right )Beta levered=Beta unlevered(1+Equity(1tax rate)Debt)

If a company increases its debt to the point where its levered beta is greater than 1, the company's stock is more volatile than the market. If a company decreases its debt to the point where its levered beta is less than 1, the company's stock is less volatile than the market. If a company has no debt, its unlevered beta and levered beta would be equal.

High Debt and Stock Volatility

Both unlevered beta and levered beta measure the volatility of a stock in relation to movements in the overall market. However, only levered beta shows that the more debt a company has, the more volatile it will be in relation to market movements.

Leverage is the amount of debt a company incurs to fund its assets and growth. For example, a company may borrow money to undertake a project, build a new manufacturing plant, or make an investment it hopes will increase its rate of return.

If a company has more debt than equity, then it's considered to be highly leveraged. If the company continues to use debt as a funding source, its levered beta could grow to be greater than 1, which would then indicate the company's stock is more volatile compared to the market. High volatility means the price of the stock could swing dramatically in either direction over a short time.

Investors can also evaluate market volatility through the Volatility Index or VIX, which the Chicago Board Options Exchange created to gauge the 30-day expected volatility of the U.S. stock market.

Evaluating Companies

While a company's levered beta shows the amount of volatility that can be associated with its capital structure, it is ineffective when comparing the volatility of two different companies. Since capital structures vary across different companies, it doesn't make sense to compare the levered betas of two companies.

Instead, use the unlevered beta to compare the betas of two different companies. If you want to understand the volatility of a specific company, including its capital structure, use the levered beta.