Session 11: Estimating Hurdle Rates - More on bottom up betas

New Section

In this section, the speaker delves into the concept of estimating betas for global companies and how to apply this approach to estimate the beta for a private business.

Estimating Betas for Global Companies

• The speaker introduces the notion of bottom-up betas, emphasizing the importance of estimating betas for individual businesses within a company to calculate the cost of equity.

• Using Vale, a global mining company incorporated in Brazil, as an example, the speaker breaks down Vale's operations into four businesses and identifies publicly traded comparable firms for each segment to estimate unlevered betas.

• By leveraging regression betas from comparable global companies, the speaker calculates unlevered betas by business for Vale and determines a weighted average unlevered beta of approximately 0.84 for Vale's operations.

Cost of Equity Calculation

• The speaker explains how they determine a levered beta and cost of equity for Vale by using a consistent debt-to-equity ratio across all businesses within Vale due to their similar debt needs.

• To assess Vale in US dollar terms despite being a Brazilian company, the speaker uses the US dollar risk-free rate and computes a weighted average equity risk premium reflecting Vale's international presence.

Currency Conversion for Cost of Equity

• When converting the US dollar cost of equity to nominal Reai cost of equity, the speaker highlights using expected inflation rates in both currencies as key factors in this conversion process.

• By adjusting for inflation rates between currencies, one can efficiently convert a US dollar cost of equity into a nominal Reai cost of equity without starting from scratch.

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New Section

In this section, the speaker discusses the process of determining the cost of equity for companies like Tata Motors and Baidu by considering factors such as currency choice, beta estimation, and equity risk premium calculation.

Determining Cost of Equity

• The speaker emphasizes the importance of selecting an appropriate currency for risk-free rate calculations and explains how to compute the cost of equity using factors like beta and equity risk premium.

• Currency choices, business mixes, betas, country selections, and graphical breakdowns play crucial roles in estimating the cost of equity through a bottom-up beta approach.

• When analyzing companies like Deutsche Bank with multiple businesses, it is essential to calculate average regression betas for each business segment rather than unlevering and relevering betas due to challenges in determining debt-to-equity ratios for banks.

• The speaker advises against unlevering and relevering betas for financial service companies. Instead, he suggests using levered betas by business to determine the cost of equity efficiently.

New Section

This section delves into the advantages of utilizing bottom-up betas over regression betas in estimating costs of equity for various types of businesses.

Benefits of Bottom-Up Betas

• Bottom-up beta computation allows for a detailed analysis based on a company's business values rather than relying on regression betas alone.

• The approach used can be applied not only to public companies but also to private businesses or divisions within publicly traded firms by assessing their specific industry characteristics.

• An example involving an independent bookstore called Bookscape illustrates how to compute a bottom-up beta using publicly traded book companies' data and adjusting for industry-specific metrics like debt-to-equity ratios.

New Section

This part focuses on refining cost-of-equity calculations for private businesses like Bookscape by incorporating additional risks faced by owners due to lack of diversification.

Refining Cost-of-Equity Calculations

• The speaker explains how to derive a pure play beta for a private bookstore like Bookscape based on publicly traded book companies' data while considering cash percentages and industry specifics.

• Estimating market debt-to-equity ratios can be challenging for private businesses; hence, assumptions are made regarding these ratios when calculating levered betas and subsequently determining costs of equity.

New Section

In this section, the speaker discusses the process of calculating total beta and its significance in determining the cost of equity for a business.

Calculating Total Beta

• The speaker averages out the R-squared values from the regression beta page to determine how much variance in companies is explained by the market.

• To calculate total beta, the speaker divides the market beta by the correlation value obtained from taking the square root of R-squared.

• Adjusting the market beta for additional risk due to lack of diversification provides a more accurate hurdle rate and cost of equity for decision-making.