This is one time I wish Chad would ban somebody for being a dumbass. Zesty - the discussion is no longer centered on Yahoo vs Google - it is now a DIRECT discussion (if you can call one idiot with a 3.2 in his shi-tacular MSF program and who is sitting for the LI exam in June arguing with people vastly more intelligent and succesful, not only in finance but in life, a ‘discussion’) as to whether or not leverage plays a role in an equity securities beta. With that being stated, and I know that you won’t answer this - but I want to at least give you the opportunity: For the EXACT same company, will the levered beta be different if the capital structure is dramatically different (say 0% debt verse 90% debt)? This question answers whether or not leverage impacts beta, which is why I know you won’t answer it.
Mobius Striptease Wrote: ------------------------------------------------------- > i’m hoping your MSF degree stands for Masters of > Science Fiction. ^lol
4 pages for this ? Why didn’t you refer him to L2 material and end the discussion there 3 pages ago? (I hope I did not mess up the grammar this time) .
Zesty Wrote: ------------------------------------------------------- > @ Mobius Striptease, you can tell when someone is > losing an argument, they start insulting the other > person. All I’m asking for is data that supports > your theory of there being a relationship with > stock volatility/price movements and leverage (all > I want is data; is that so hard to ask for) Before the CFA I was under the impression that Beta was just a measure of normalized covariance. But in reality you will find out in L2 that it’s actually related to the financial statements and you will learn how to break it down into two pieces for the purpose of calculating the cost of capital for a company (public or private).
@ zetsy and bchad, i think i figured out what the problem is. let assume that apple’s earnings fluctuate by 10% for every 10% fluctuation in the market over the long-term. a rough, but fair assumption. lets also assume apple’s expected cash flow is $5 and its valued using dcf. lets also assume to scenarios: 1) apple keeps their balance sheet clear of debt. if the market were to increase by 10%, apple’s cash flow will increase by 10%, and its share price will increase by (10% x share price) * CF multiple. 2) apple buys back 50% of its equity with newly issued debt (lets say the i rate is 0% for argument sake). this will result in earnings of $10 to the remaining equity instead of $5 and its share price will instantly double. if the market were to increase by 10%, its share price will increase by (10% x share price) * CF multiple. if the CF multiple is the same for both scenarios above, their st. deviation will be 100% the same. this is because the debt-laden apple shares have already appreciated to the point where the % changes are the same. now the question arises, should the CF multiple be different? and the answer is know one could ever know. if by levering up, apple now has no new leverage capacity available, this could in fact reduce its CF multiple. the fact that apple has plenty of financial flexability warrants it with an above average CF multiple, so its possible that giving up the financial flexability for levered returns could be a no-sum gain to beta, post debt issuance. i fully comprehend both povs and its difficult to side with one or the other. my education tells me to side with bchad and my experience tells me to side with zetsy.
MattLikesAnalysis Wrote: ------------------------------------------------------- > 2) apple buys back 50% of its equity with newly > issued debt (lets say the i rate is 0% for > argument sake). this will result in earnings of > $10 to the remaining equity instead of $5 and its > share price will instantly double. if the market > were to increase by 10%, its share price will > increase by (10% x share price) * CF multiple. Wow. How many mistakes are here. Let’s start counting… 1. Debt isn’t costless (unless you’re chuck norris). Especially if D/MC = 100% (and for this firm, probably you now have debt equaling a significant multiple of Assets, for net negative book equity). I hope you understand why this is very important, and renders the rest of the argument meaningless. 2. Incremental share repo doesn’t normally change share price. So if your conclusion is that the price changed, you have achieved the first part of a proof by contradiction. Go back and find the mistaken assumption. 2a. However, this situation isn’t normal: you’ve shocked the cap structure. With the relatively huge amount of debt you’ve put on this firm, the share price will probably drop. 3. Beta rises beyond the debt-free value of 1.0 as soon as you lever the firm. So your 10%-to-10% argument fails.
jcole21 Wrote: ------------------------------------------------------- > This is one time I wish Chad would ban somebody > for being a dumbass. > > Zesty - the discussion is no longer centered on > Yahoo vs Google - it is now a DIRECT discussion > (if you can call one idiot with a 3.2 in his > shi-tacular MSF program and who is sitting for the > LI exam in June arguing with people vastly more > intelligent and succesful, not only in finance but > in life, a ‘discussion’) as to whether or not > leverage plays a role in an equity securities > beta. > > With that being stated, and I know that you won’t > answer this - but I want to at least give you the > opportunity: > > For the EXACT same company, will the levered beta > be different if the capital structure is > dramatically different (say 0% debt verse 90% > debt)? This question answers whether or not > leverage impacts beta, which is why I know you > won’t answer it. This is the point I was trying to illustrate 3 pages ago… alas, he didn’t go for it. Have we confirmed if Zesty is L1, L2 or L3? God save the Charter if he’s 3 with us.
He couldn’t even be level 2 or else he wouldn’t be arguing that fixed costs have nothing to do with a companies beta. Unless he’s trying to pass level 2 without reading the textbooks.
Reggie Wrote: ------------------------------------------------------- > He couldn’t even be level 2 or else he wouldn’t be > arguing that fixed costs have nothing to do with a > companies beta. Unless he’s trying to pass level 2 > without reading the textbooks. get em Reggie Bush
I have a stock, priced at $100. It’s value goes up by 2% today. Yay. It’s now worth $102. I earned 2% === Scenario 2) I borrow $50 from my brother, who is nice enough not to charge me interest. This time I add $50 equity of my own and go buy the stock, which is selling for $100. The stock’s value goes up by 2% today. Yay! It’s now worth $102. I sell the stock, pay back 50 to my brother who is happy because now I have to babysit his kid while he goes out on date night. Meanwhile I have $52, whereas I had $50 the day before. The stock only earned 2%, but I have a $2/$50 or 4% gain. === Additional Analysis Suppose the on this stock is 2, and the alpha is zero, and suppose there is no noise today. This implies that: 1) The market went up by 1% 2) The stock went up by 1% * Stock Beta = 2% 3) My equity went up by 2% * Stock Beta * Leverage Factor = 4% ==== How does this compare to company analysis and company debt ratios? It’s the same thing. Suppose you have a company that is all equity. Let’s say it’s beta (when there is no debt) is 2. When the market goes up 1%, the value of the *entire company* goes up 1% * Beta = 2%. That’s what unlevered beta (also known as asset beta) is. But now, let’s say the company has 50% debt, at zero interest, because it’s a pet project of some government official. Now, when the market goes up 1%, the value of the *entire company* goes up 2% still, because the company’s unlevered beta (measuring business risk) is unaffected by leverage ratios. However, the increase in company asset value is now based off of an equity book value that is 1/2 the size as before, because 1/2 of the company assets are debt. Therefore the leverage factor is 2. The value of the company equity goes up by 4% (mkt % * asset beta * financial leverage). What this means is that the company with debt has a beta of 4 (1% market change, 4% increase in equity), whereas the company without debt has a beta of 2 (1% market change, 2% increase in the value of company assets). Now there is an issue which is that the leverage factor will change over time unless new debt is accrued or paid off to maintain a constant debt-equity ratio, but the overall effect of debt is unmistakable. I still don’t understand why the after-tax debt ratio appears in the levering formula, however, since the calculations of these short-term effects seem are more-or-less irrelevant to the interest payments. Perhaps there is some strange effect of the present value of future interest payments that I’m not aware of.
bchadwick Wrote: ------------------------------------------------------- > Near death experience would be an alpha factor, > not a beta. Beta just tells you how the stock > reacts to factors that are common to the stocks in > general. > > Also, yahoo and google may have different debt > levels, which also affects beta. After several years of agreeing with bchad, I think I have to disagree – partially – here. The OP suggested that CAPM is broken, since he thinks yhoo’s required return should be greater than goog’s. (Or maybe he’s an undiversified investor?) bchad counters (a) (diversified) investors don’t demand extra return for idiosyncratic risk; (b) goog’s asset beta may be lower than yhoo’s. I take issue with (b). I think that argument only makes sense for the investor who’s spread across the capital structure (i.e., taking positions in both goog’s debt and equity), and thus is exposed to asset beta. I think however we’re speaking of just common equity investors. For them it doesn’t matter how much leverage is on the firm; if they buy the stock they’re exposed to the levered beta.
Die thread die
Honestly, in reality I think it really boils down to behavioral stuff. I agree with a previous poster that Google is a much more closely followed stock and much more apt to be affected by over and under reactions by market swings. I’m coming to the conclusion that 90% of the stuff we learn in academic finance is BS because in the end most investors are stupid, irrational, and idiotic. However, in terms of the theory… bchad is right.
bchadwick Wrote: ------------------------------------------------------- > I still don’t understand why the after-tax debt > ratio appears in the levering formula, however, > since the calculations of these short-term effects > seem are more-or-less irrelevant to the interest > payments. Perhaps there is some strange effect of > the present value of future interest payments that > I’m not aware of. Because the beta of the tax shield is assumed to be 0. So the portion of the company’s value attributable to this shield isn’t impacted by market movements; and we need to haircut levered beta downward a bit.
DarienHacker, what do you do for a living?
DarienHacker Wrote: ------------------------------------------------------- > bchadwick Wrote: > -------------------------------------------------- > ----- > > Near death experience would be an alpha factor, > > not a beta. Beta just tells you how the stock > > reacts to factors that are common to the stocks > in > > general. > > > > Also, yahoo and google may have different debt > > levels, which also affects beta. > > After several years of agreeing with bchad, I > think I have to disagree – partially – here. > > The OP suggested that CAPM is broken, since he > thinks yhoo’s required return should be greater > than goog’s. (Or maybe he’s an undiversified > investor?) > > bchad counters (a) (diversified) investors don’t > demand extra return for idiosyncratic risk; (b) > goog’s asset beta may be lower than yhoo’s. > > I take issue with (b). I think that argument only > makes sense for the investor who’s spread across > the capital structure (i.e., taking positions in > both goog’s debt and equity), and thus is exposed > to asset beta. I think however we’re speaking of > just common equity investors. For them it doesn’t > matter how much leverage is on the firm; if they > buy the stock they’re exposed to the levered beta. I don’t mind being challenged, but I don’t think that I’ve said what you say I said. I have no idea why Yahoo’s beta is different from Google’s. I’m just saying that it might be because of leverage, it might be because of correlation, and it might be because they are actually in different business segments with different amounts of business (asset beta) risk. Which it is, I don’t know. Your point about CAPM is more subtle. I didn’t see the OP’s post as a criticism of CAPM, although I can see how one could might interpret it that way. My point is that the near-death experience of Yahoo is a company-specific risk, not a broad systemic risk, and therefore whatever return compensation for the shadow of history is demanded should be more-or-less independent of beta. I think that a near-death experience and also a takeover risk (remember Microsoft flirting with a yahoo takeover) both could contribute to a premium that investors might be compensated for taking. That would challenge CAPM but be perfectly workable under some other model that includes a premium for market risk, plus some kind of premium for “history-repeats-itself-risk.” My only point is that that risk probably won’t be reflected much in the beta to the market factor, since it is a company specific risk. (I’m not terribly dogmatic on that point, BTW, since I can see how - if investors are more extra optimistic about Yahoo when the market is up and extra pessimistic when the market is down, that would effectively increase the market’s beta, but that’s a more complex analysis).
According to Bloomberg, Yahoo has a Beta of 1.05 and Google of 0.97. Both companies have large net cash positions. These figures are quite different to the betas Achilles originally posted. I presume his were based off a different timescale to whatever Bloomberg uses as its default. That’s a pretty big problem with using beta for any kind of calculation - there is no definitive way of measuring it. Personally, I don’t bother with beta. I know people use it for CAPM etc but I don’t agree wiith that. If you don’t have confidence in the data you are using, you should simply drop it. I don’t see how anyone can have confidence in beta as a meaningful measure of anything.
DarienHacker Wrote: ------------------------------------------------------- > MattLikesAnalysis Wrote: > -------------------------------------------------- > ----- > > 2) apple buys back 50% of its equity with newly > > issued debt (lets say the i rate is 0% for > > argument sake). this will result in earnings of > > $10 to the remaining equity instead of $5 and > its > > share price will instantly double. if the > market > > were to increase by 10%, its share price will > > increase by (10% x share price) * CF multiple. > > Wow. How many mistakes are here. Let’s start > counting… > > 1. Debt isn’t costless (unless you’re chuck > norris). Especially if D/MC = 100% (and for this > firm, probably you now have debt equaling a > significant multiple of Assets, for net negative > book equity). I hope you understand why this is > very important, and renders the rest of the > argument meaningless. > > 2. Incremental share repo doesn’t normally change > share price. So if your conclusion is that the > price changed, you have achieved the first part of > a proof by contradiction. Go back and find the > mistaken assumption. > 2a. However, this situation isn’t normal: you’ve > shocked the cap structure. With the relatively > huge amount of debt you’ve put on this firm, the > share price will probably drop. > > 3. Beta rises beyond the debt-free value of 1.0 as > soon as you lever the firm. So your 10%-to-10% > argument fails. how many mistakes are here. lets start counting. 1) arguing the difference between a 5% interest rate and a 0% interest rate shows how far you’re reaching… its not going to change the overall concept, or divide who is right and who is wrong 2) how will buying back 50% of all outstanding stock in the free market not increase its price? i dare you to buy 450 million shares of aapl and expect the price to remain the same. if the company does it, it still pushes the price up. and if the stock price reflects any rational relationship with the underlying business, the earnings/cf per share will double, and the stock price should follow. if this is too hard to understand, assume it paid out a 10% dividend. if 50% of the stock was replaced with debt and the overall dividend size remains the same, the dividend increases to 20%, but because the stock still reflects the same company, investors will buy the stock up to the price where the stock yields 10%, i.e. the stock will double. if the stock doubles, which is 100% guaranteed, and market moves reflect changes in economic figures/forces, then betas between the unlevered and levered companies will be the same. 3) beta is essentially useless when valuing companies that rely on dcf and cash flow multiples for valuation, like apple. this isn’t capm. capm is useless for apple. at least in the real world with real analysts. i know the above does not comply perfectly with the cfa textbooks. i went 3/3 on the exams so i am well aware of the content in the cfa program. but living in a tech town and studying tech companies for the past 30 months allowed me to realize that beta means nothing with a tech stock. cash flow means everything. thus, it is possible that zetsy has a leg to stand on in this argument.
OK, Matt, I can see the argument that beta is irrelevant to the stock’s performance because the noise from other factors is too large and is potentially tractable from other information, such as knowledge of the company’s cash flow. That seems plausible to me. But that’s not Zesty’s argument (at least not as Zesty presented it here). Zesty’s argument is that beta is what you get when you regress a company’s stock returns on the market return, and therefore company’s debt level has nothing to do with beta. That argument is simply wrong. Adding leverage to the capital structure will make the stock more volatile because all of the cash flow or net income is now going to be measured off of a smaller equity value. The increase in volatility with essentially change in correlation will increase beta. Whether or not beta is the most important statistic to be paying attention to is another question. If the R^2 on your CAPM or APT model is very low, then there’s lots of reasons to be looking for other explanatory factors for stock performance. Beta can be high and R^2 is low, so you might not pay much attention to beta in that case.
sorry. i have to add this, my edit timed out. i initially stated “using the dcf” which is incorrect. using a cf multiple method. the only argument that can possibly beat my argument is that levering the balance sheet will increase cash flow beyond 2x, without affecting the cash flow multiple negatively. the problem with cash flow multiples is that they are subjective and analysts give higher multiples to those companies with leverage room and punish those with little room for leverage. i’d conclude that using a small amount of leverage will likely raise a stock’s beta, but fully levering may result in identical unlevered and levered betas. and yes bchad, you nailed it on the head. i’m glad someone on this forum still reads posts before posting ridiculous things. i’m arguing something else, but it indirectly supports zetsy’s argument. i feel he may be arguing the wrong thing or arguing something in the wrong way. from my understanding of zetsy’s ramblings, he’s stating that debt levels affecting betas is inconclusive in general, and that my argument is a clear description of how that is true in the real world.