Debt beta is the result of the ratio of credit spread and market risk premium. If it is taken into account, the company value usually increases.
In the context of CAPM, beta represents the risk measure for the so-called systematic risk. This means that part of the fluctuation of an equity return that cannot be eliminated even within a fully diversified equity portfolio and must therefore be borne by the investor.
The beta factor in CAPM is an expected value
Risk-averse investors within the meaning of the CAPM expect compensation for this part of the risk in the form of a risk premium. The price of risk is the so-called market risk premium; the amount of risk is measured by the beta factor. The price of risk multiplied by the amount of risk results in the amount of the total risk premium of the return on equities.
The parameters in the context of CAPM future-oriented expected values. This applies in particular to the expected covariances in equity returns, which are ultimately decisive for the formation of the fully diversified equity portfolio.
The beta factor, as one of the price-determining elements of the expected return on equities, is also an expected value. The classic, direct empirical determination of beta factors is based on historical equity returns.
Empirically measured beta factors have a tendency towards so-called mean reversion
In valuation practice, the beta factor is determined by drawing on historical capital market data. Methodically, this is not a problem, but it raises the question of the extent to which historical data can be a good indicator of the future risk profile of an investment.
Statistically, empirically determined betas actually show a so-called “mean reversion” property against a value of 1. Historical beta greater than 1 have a tendency to fall against 1 betas less than 1 have a tendency to rise towards 1.
Flower adjustment as a good compromise for valuation practice
The mean reversion characteristic generally indicates that historical betas only appear to a limited extent suitable for future-oriented company valuations. However, this problem can be minimized by using adjusted beta instead of (measured) raw beta.
The so-called flower adjustment (M. Bume 1971) is the most commonly used adjustment. The temporal instability and backward tendency of the beta factor towards 1.0 is approximate in the flower adjustment by the following equation:
adjusted beta = α0 +α1 * raw beta with α0 = 1/3 and α1 = 2/3
The adjusted beta is therefore determined here by a mean reversion process, which includes the historically measured beta with a coefficient of 2/3. In addition, there are also significantly complex adjustment algorithms (including O. Vasicek, 1973), but the relatively easy-to-use and sufficiently valid flower adjustment has ultimately become established in evaluation practice.