Aswath Damodaran
SESSION 5: RELATIVE RISK
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It’s all relative
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The Default: The CAPM Beta
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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?
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Beta Estimation: Is this Embraer’s beta?
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Or is this it?
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And watch out if your regression looks too
good…
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Determinants of Betas
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Bottom-up Betas
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Why bottom-up betas?
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It is more precise.
Average Std Error across Betas
Number of firms in sample
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It can be adjusted to reflect current and even future business mixes.
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It can be estimated for a non-traded asset or business.
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Estimating a bottom up beta for Embraer in
2004
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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?
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Bottom-up Beta: Firm in Multiple Businesses
SAP in 2004
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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%)
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You don’t like betas…
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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.
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