TOWARD A BETTER BETA
The determination of a robust proxy for systematic risk (beta) is often a problematic part of a WACC calculation, especially for business units, private companies, illiquid stocks and public companies with little meaningful historical data. Beta is typically the regression coefficient that describes the slope of a line of “best fit” through a history of dividend-adjusted stock and market returns. Though betas can be reasonable and statistically meaningful, they can be difficult to determine, so do not throw out the baby with the bathwater. We will provide some alternative methods to apply the CAPM with a reliable measure of systematic risk.
Most typically calculated using the most recent 60 monthly returns, other sampling periods and frequencies can be more appropriate. For example, for sectors affected by the tech bubble or 9/11 a three-year sampling of weekly data may be more appropriate. How much history is relevant to your company or industry? Beyond a qualitative assessment for fundamental changes in risk, check the data.
Potential questions might probe the interpretation and sensibility of the regression coefficients, summary statistics, and residuals. Sorting the residuals will help you to flag and understand suspect data, as well as to guide your choices regarding the amount of history and length of the return periods to be used. If no discernible trend is evident and the data represent a random walk, longer periods can be employed ...