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What is 'Unlevered Beta'

Unlevered beta compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta of a company without taking its debt into account. Unlevering a beta removes the financial effects of leverage. This number provides a measure of how much systematic risk a firm's equity has when compared to the market.

Unlevered Beta formula

Unlevered beta is also called asset beta.

BREAKING DOWN 'Unlevered Beta'

Unlevering the beta removes any beneficial effects gained by adding debt to the firm's capital structure. Comparing companies' unlevered betas gives an investor a better idea of how much risk he is taking on when he purchases the stock.

In finance, beta is a measure of risk. Specifically, it is the slope of the coefficient for a stock regressed against a market index like the Standard & Poor's (S&P) 500 Index. Unlevered beta removes the impact of debt or leverage on the regression.

Systematic Risk and Beta

Systematic risk is the type of risk that is caused by factors beyond a company's control. This type of risk cannot be diversified away. Examples of systematic risk include natural disasters, political events, inflation, and wars. To measure the level of systematic risk or volatility of a stock or portfolio, the beta is used.

Beta is a statistical measure that compares the volatility of the price of a stock against the volatility of the broader market. If the volatility of the stock, as measured by beta, is higher, the stock is considered risky. If the volatility of the stock is lower, the stock is said to have less risk.

A beta of 1 is equivalent to the risk of the broader market. That is, a company with a beta of 1 has the same systematic risk as the broader market. A beta of 2 means the company is twice as volatile as the overall market, but a beta of less than 1 means the company is less volatile and presents less risk than the broader market.

Unlevered Beta

A key determinant of beta is leverage, which measures the level of a company’s debt to its equity. Levered beta measures the risk of a firm with debt and equity in its capital structure to the volatility of the market. The other type of beta is known as unlevered beta.

Unlevered beta measures the risk of an investment by comparing the market to a company with no debt. Unlevered means no leverage. Leverage means debt. Therefore, unlevered means no debt.

The level of debt that a company has can affect its performance, making it more sensitive to changes in its stock price. Note that the company being analyzed has debt in its financial statements, but unlevered beta treats it like it has no debt by stripping any debt off the calculation. The more debt or leverage a company has, the more earnings are used to paying back that debt. This increases the risk associated with the stock. Since companies have different capital structures and levels of debt, to effectively compare them against each other or against the market, an analyst can treat them as unleveraged by using the unlevered beta which does not take into account the company’s financial leverage and the impact of its debt on its performance. This way, only the sensitivity of a firm’s equity to the market will be factored.

To unlever the beta, the levered beta for the company has to be known in addition to the company’s debt-equity ratio and corporate tax rate.

BU = BL / [1 + ((1 - Tax Rate) x Debt/Equity)]

Let’s calculate the unlevered beta for Tesla, Inc. As of November 2017, its beta is 0.73, D/E ratio is 2.2, and its corporate tax rate is 35%.

Tesla BU = 0.73 / [1 +((1 – 0.35) x 2.2)] = 0.73 / 1 + (0.65 x 2.2) = 0.73 / 2.43 = 0.30

Unlevered beta will always be lower than levered beta. If the unlevered beta is positive, investors will invest in the company's stock when prices are expected to rise. A negative unlevered beta will prompt investors to invest in the stock when prices are expected to decline.

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