Deleveraging the beta

A common problem when looking at the market valuation of companies is that we’re looking at numbers which are net of leverage.

In simple terms, ignoring some marginal sideshows, the balance sheet of a company is formed of asset and liabilities where:

  • Liabilities = debt + equity
  • Assets = cash + stuff (inventory, equipment) + intellectual property (aka intangible assets)

By construction of double entry accounting, liabilities = assets, that is equity = assets – liabilities (aka net assets). What the shareholders own is what is left over if the components of a business were to be sold separately (the accounts are an estimate of this resale value).

Accounts don’t formally include as an asset the value of the business as the whole of its parts, unless a third party business is bought in, which gives a price for this, known as “goodwill”. The goodwill of the whole business is the difference between the balance sheet valuation and the market’s, which for well run businesses is higher (the business is worth more than the sum of its parts, e.g. a tire manufacturer is worth more than tires in stock and the building in which they’re made).

Accounting for goodwill as an asset of the acquiring business allows it to track whether it made a mistake when buying another business. This is useful for the acquiring business but muddles the accounts for the outside observer wishing to compare a business which grew by acquiring smaller competitors vs. one which grew organically. This particular problem is relatively easy to solve by looking at valuations less the goodwill element of the balance sheet (with an equal amount deduced from accounting equity).

At the whole company level we still have the problem we compare the market valuation to the accounting valuation (aka equity) net of debt. For two identical companies with different level of debts the numbers will look different while the reality isn’t necessarily. For example if company A has a balance sheet value of 100 formed of 80 of debt and 20 of equity, a market cap of 60 is 3 times equity. If we assume the value of the debt in the accounts is fair value, the total value of the company to debt and equity holders combined is 140 (80 + 60). An otherwise identical company with no debt also valued the same would have 100 of equity and a market cap of 140, 1.4 times book value, very different but for the same thing net of leverage.

While leverage must be accounted for at some point — the equity holder of the leveraged company has really more up/downside for each unit of investment — it makes numbers less comparable when trying to see what the market price of a business is and how the total valuations compare when companies have different structures.

Simply deducting the book value of the debt in the accounts, as is sometimes done, is not necessarily accurate, because debt is accounted for at discounted face value, which is fair from the point of view of the company — it must repay face value when debt matures — but may differ from what the market thinks they will get back. As chance would have it, there is a secondary market for debt, at least for large companies whose debt consists mostly of corporate bonds or notes.

So an interesting number would be the market cap of a company obtained by unfolding all classes of publicly listed debt and equity, and use that number with the correspondingly unfolded balance sheet numbers. This would indicate at how much collectively all public stakeholders of a company value it, and should produce more comparable numbers than the usual numbers people look at (even though some class of liabilities lacking a public price will unavoidable be excluded).

It would be interesting to see what happens to beta in those case. Beta is an approximative measure to how much an individual stock price is sensitive to whole-of-market prices. Raw beta thus include both leverage effect, and the effect of all other reasons that make a company more or less sensitive to market moves. A deleveraged beta could be calculated, for all companies whose debt is public enough.

It may have been done although I know of no easily accessible source of such numbers (as in with the calculation done, I believe all the input data necessary is public, it’s just not trivial to unfold). If available it may allow to answer some interesting questions:

– are there material differences between deleveraging the beta using the market value of debt and that obtained using its book value?

– does the low volatility anomaly persist in deleveraged beta space? (I suspect it does)

– is there a “money illusion” type of effect where looking at the equity beta obscures facts that would be obvious to a deleveraged beta observer? (I suspect there is)

– and surely many more…

Update (12/2012): the wheel I was reinventing here is called Enterprise Value, a metric that deserves higher visibility.


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