The act of "unlevering" beta involves extracting the impact of debt obligations of a company before evaluating an investment's risk in comparison to the market. Unlevered beta is considered useful because it helps to show a firm's asset risk compared with the overall market. For this reason, the unlevered beta is also sometimes referred to as the asset beta.
Beta is unlevered through the following calculation:
Levered beta / 1 + ((1 - tax rate) x (Total Debt/Total Equity))
Beta versus Unlevered Beta
In technical terms, beta is the slope coefficient of a publicly traded stock’s returns that have been regressed against market returns (usually the S&P 500). By regressing a stock's return relative to a broad index, investors are able to gauge how sensitive any given security might be to macroeconomic risks.
As companies add more and more debt, they are simultaneously increasing the uncertainty of future earnings. In essence, they are assuming financial risk that is not necessarily representative of the type of market risk that beta aims to capture. Investors can then accommodate for this phenomenon by extracting the potentially misleading debt impact. Since a company with debt is said to be leveraged, the term used to describe this extraction is called "unlevering."
All of the information necessary to unlever beta can be found in a company's financial statements where tax rates and the debt/equity ratio can be calculated. In general, the unlevered beta will always be lower than the standard, levered beta if the company has debt. Extracting the debt from the equation through the use of the debt/equity ratio will always result in a lower risk beta.
Investors can easily calculate the asset beta using the equation above. The unlevered beta is typically used in analysis alongside the levered beta to compare the risk of a stock to the market. Just like with the levered beta, the baseline is 1. When the levered beta is unlevered it may move closer to 1 or even be less than 1.
Professional analysts in investment management, investment banking, and equity research often use the asset beta to build out modeling reports that provide more than just a basic scenario. Thus, anytime beta is used in a modeling project’s calculations, an additional scenario can be added which shows effects with the asset beta.
Overall, the use of asset beta provides a deeper analysis of a company’s risks with a focus on the company’s debt. It is important when making any type of beta comparison that the betas aren’t confused and identical metrics are used. Typically, the use of asset beta is also further accompanied by a look at the company’s debt. If a company has a relatively higher debt to equity ratio but the debt is AAA-rated it may be of less concern than a high debt to equity ratio with a junk debt issuance.
(For more on unlevered beta: How does debt affect a company's beta?, Why You Need to Unlever the Beta When Making WACC Calculations, How do you calculate beta in Excel?)