By Andrew Meerburg
I came across a great article about Beta, a key determinant of the discount rate used in business valuations which in turn drives the value of your business. It reminded me of the high-level hack I use when reviewing the Beta used in a business valuation.
To recap, Beta is a measure of the risk of a particular market sector versus the risk of the total market and is measured by how the price of a particular sector moves versus the price of the total market. By means of an example, assuming the total market price is the JSE ALSI, and your sector is the retail sector, then a Beta of 1 would indicate that the price of all retail companies moves by the same amount as the price of the JSE ALSI and are viewed as having the same risk as the total market.
Why is this important?
A high Beta means that the sector is viewed as riskier than the total market. Investors would therefore require a higher return to compensate for their risk and would expect to pay relatively less for businesses in that sector.
Beta is driven by 3 factors and considering we are dealing with risk of an industry against the risk of the total market, these factors make a lot of sense. These factors are business risk, operating risk, and financial leverage.
Business risk
Driven by the level of discretionary vs non-discretionary spend in that industry. For example; if the economy hits a downturn, non-discretionary spends, like food, will not be as severely affected as the white goods industry where purchase can be delayed, making the food industry less risky and justifying a lower Beta.
Operating risk
The higher the fixed costs, the greater the leverage, which leads to increased risk and a higher Beta. A good example is the retail sector, which has a high variable cost related to the cost of sales and a comparatively lower fixed cost base. In contrast, the airline industry has higher fixed costs, resulting in higher operating leverage.
Financial Leverage
This is the risk associated with using debt. The more debt a company has, the greater the risk and the higher the Beta. When calculating Beta, it is simple to remove the impact of debt, a subject for another day.
The beauty of the “hack” is the ability to check the reasonability of the final Beta by looking at these 3 easy to determine factors. I don’t want to be hung out to dry by other business valuation experts but in certain circumstances one could even determine a Beta based on these factors if the purpose of the business valuations wasn’t too mission critical.
Agilequity specialises in valuing businesses. If you would like to know more about our services, we would be happy to have a free half an hour consultation about your business valuation.
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