Aswath Damodaran SESSION 5 RELATIVE RISK Aswath Damodaran

Aswath Damodaran SESSION 5: RELATIVE RISK ‹#› Aswath Damodaran 1

It’s all relative 2 Aswath Damodaran 2

3 Aswath Damodaran ‹#›

The Default: The CAPM Beta 4 Rj = a + b Rm The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. This beta has three problems: � High standard Error � Backward looking (Business Mix and Leverage) � Non-traded assets? Aswath Damodaran 4

Beta Estimation: Is this Embraer’s beta? 5 Aswath Damodaran 5

Or is this it? 6 Aswath Damodaran 6

And watch out if your regression looks too good… 7 Aswath Damodaran 7

Determinants of Betas 8 Aswath Damodaran 8

Bottom-up Betas 9 Aswath Damodaran 9

Why bottom-up betas? 10 It is more precise. It can be adjusted to reflect current and even future business mixes. It can be estimated for a non-traded asset or business. Aswath Damodaran 10

Estimating a bottom up beta for Embraer in 2004 11 The average unlevered beta for global aerospace companies was 0. 95. Apply Embraer’s gross debt to equity ratio of 18. 95% and the Brazilian marginal tax rate of 34% Business Levered Beta = Unlevered Beta ( 1 + (1 - tax rate) (D/E Ratio) = 0. 95 ( 1 + (1 -. 34) (. 1895)) = 1. 07 Why global? Where is the country risk? Aswath Damodaran 11

Bottom-up Beta: Firm in Multiple Businesses SAP in 2004 When you have multi-business company, beta will be weighted average of business betas SAP is in three business: software, consulting and training. Business Revenues EV/Sales Value Software Consulting SAP $ 5. 3 $ 2. 2 $ 7. 5 3. 25 2. 00 17. 23 4. 40 21. 63 Weights Unlevered Beta 80% 1. 30 20% 1. 05 1. 25 Levered Beta = 1. 25 (1 + (1 -. 32)(. 0141)) = 1. 26 (Tax rate =32%; D/E =1. 41%) Aswath Damodaran 12

You don’t like betas… 13 If you don’t like betas, use another measure of relative risk. Here is a simple guideline � Bothered by differences in service estimates? Use sector average or bottom up betas � Bothered by focus on market risk? Use relative standard deviation. � Bothered by stock-price basis? Use accounting risk measures � Bothered by absence of qualitative risk factors? Use a qualitative measure of risk. Aswath Damodaran 13