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The total beta of a company is an extended version of the beta coefficient and takes into account not only the systematic risk of the company but also the financial risk. Is this a useful key figure for SMEs?

The total beta of a company is an extended version of the beta coefficient and takes into account not only the systematic risk of the company but also the financial risk. Is this a useful key figure for SMEs?

The Capital Asset Pricing Model (CAPM) is based on the assumption that investors are risk-averse. In the 1960s, Sharpe, Lintner & Mossin deduced that capital markets participants generally follow the principle of risk diversification, which is reflected in the expected return on their investments and is ultimately expressed in the beta factors. But how should publicly traded, small and medium-sized enterprises be valued? Is the total beta approach an elegant solution for the valuation of SMEs?

The total beta equation is developed in different ways, but generally results in the following valuation equation:

It can be seen that the beta factors of the CAPM have been replaced by the so-called total beta. The total variance of a share has now replaced the covariance of share returns and market returns as the price-relevant factor. The equation is similar to the capital market line, but does not apply to a portfolio of shares, but to an individual company.

The CAPM has been the subject of controversial debate in the literature. The fact that almost no investor is fully diversified in the sense of the CAPM was also the subject of discussion. This assumption is by no means true even for investors in large, listed stock corporations.

In valuation practice, however, this circumstance particularly affects SMEs. Their owners often have little or no diversification. Their involvement as founders and managing directors regularly means that a large proportion of their private assets are tied up within "their own" company. The total beta approach is a valuation concept that takes into account the special circumstances of an undiversified investor and is intended to enable the valuation of SMEs.

The creation of a new theory to explain equilibrium states on the stock market seems to have always been a source of heated debate among capital market research theorists and practitioners alike. Both the CAPM and the Abitrage Pricing Theory (APT; Stephen Ross 1976) have already been the subject of controversial and by no means conclusive debate in the literature. The same applies to the technical discussion surrounding the total beta approach.

While the discussion of the CAPM and the APT focused on the assumptions, the depth of content and the empirical verifiability, the total beta approach proved to be more difficult because the result equations are not free of contradictions. Kruschwitz & Löffler (Corporate Finance 06/2014) clearly highlighted the serious shortcomings of the total beta concept and emphasized its lack of suitability as a capital market model.

The total beta approach was initially seen as a promising approach to solving the problem of non-diversified investors in the valuation of SMEs. However, in the course of the expert discussion, it turned out that this hope was not justified. The total beta approach leads to elementary logical contradictions. Even the classification as a so-called "practitioner approach" due to the lack of other alternatives for the valuation of SMEs cannot compensate for this serious shortcoming.

What is Total Beta?

Total beta is an extension of the classic beta coefficient and takes into account not only the systematic risk but also the unsystematic risk of a company.

Why is total beta relevant for SMEs?

Total Beta attempts to take into account the special circumstances of SME owners, who are often less diversified and have a large proportion of their assets tied up in their own business.

Is total beta a viable solution for SME valuation?

Despite initial hopes, it has been shown that total beta leads to logical contradictions and is therefore not a reliable alternative for the valuation of SMEs.

What are the main criticisms of the total beta approach?

The main points of criticism are the lack of consistency of the result equations and the lack of suitability as a capital market model.

Are there alternatives to the total beta approach for the valuation of SMEs?

Yes, the classic application of the CAPM and other capital market-oriented models such as the Arbitrage Pricing Theory (APT) offer sound alternatives.

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