2. The market risk premium, RM − RF .
Method 1: using historical data.
Method 2: using the Dividend Discount Model (DDM). Market data and analyst forecasts can be used to implement the DDM approach on a market-wide basis.
3. The company beta,
Problems of beta:1) Betas may vary over time
2) The sample size may be inadequate
3) Betas are influenced by changing financial leverage and business risk
Solutions:i) Problems 1 and 2 can be moderated by more sophisticated statistical techniques
ii) Problem 3 can be lessened by adjusting for changes in business and financial risk
iii) Look at average beta estimates of several comparable firms in the industry
Stability of beta
Most analysts argue that betas are generally stable for firms remaining in the same industry but they can change by changes in product line, changes in technology, deregulation or changes in financial leverage.
Using an industry beta
It is frequently argued that one can better estimate a firm’s beta by involving the whole industry. If you believe that the operations are of the firm are:
- Different from the operations of the rest of the industry => use the firm’s beta
Determinants of beta: We consider three factors: the cyclical nature of revenues, operating leverage and financial leverage.
- Cyclicality of revenues. The revenues of some firms are quite cyclical. These firms do well in the expansion phase of the business cycle and do poorly in the contraction phase. Empirical evidence suggests that retailers and automotive firms fluctuate with the business cycle and on the other hand, transportation firms and utilities are less dependent on the cycle. As beta measures the responsiveness of a stock’s return to the market’s return, it is not surprising that highly cyclical stocks have high betas.
Cyclicality is not the same as variability. Stocks with high standard deviations need not have high betas.