(ii) Fundamental Betas. A second way to estimate betas is to look at the fundamen-
tals of the business. The beta for a firm may be estimated from a regression, but it is
determined by decisions the firm has made on what business to be in, how much op-
erating leverage to use in the business, and the degree to which the firm uses finan-
cial leverage. In this section, we will examine an alternative way of estimating betas
for firms, where we are less reliant on historical betas and more cognizant of their
fundamental determinants.
DETERMINANTS OF BETAS. The beta of a firm is determined by three variables: (1) the
type of business or businesses the firm is in, (2) the degree of operating leverage of
the firm, and (3) the firm’s financial leverage. Although we will use these determi-
nants to find betas in the CAPM, the same analysis can be used to calculate the betas
for the arbitrage pricing and the multi-factor models as well.
TYPE OF BUSINESS. Since betas measure the risk of a firm relative to a market index,
the more sensitive a business is to market conditions, the higher its beta. Thus, other
things remaining equal, cyclical firms can be expected to have higher betas than non-
cyclical firms. Companies involved in housing and automobiles, two sectors of the
economy that are very sensitive to economic conditions, should have higher betas
than companies in food processing and tobacco, which are relatively insensitive to
business cycles.
We can extend this view to a company’s products. The degree to which a product’s
purchase is discretionary will affect the beta of the firm manufacturing the product.
Firms whose products are much more discretionary to their customers should have
higher betas than firms whose products are viewed as necessary or less discretionary.
Thus, the beta of Procter & Gamble, which sells diapers and daily household prod-
ucts, should be lower than the beta of Gucci, which manufactures luxury products.
DEGREE OF OPERATING LEVERAGE. The degree of operating leverageis a function of the
cost structure of a firm and is usually defined in terms of the relationship between
fixed costs and total costs. A firm that has high fixed costs relative to total costs is
said to have high operating leverage. A firm with high operating leverage will also
have higher variability in operating income than would a firm producing a similar
product with low operating leverage. Other things remaining equal, the higher vari-
ance in operating income will lead to a higher beta for the firm with high operating
leverage.
Can firms change their operating leverage? While some of a firm’s cost structure
is determined by the business it is in (an energy utility has to build expensive power
plants, and airlines have to lease expensive planes), firms in the United States have
become increasingly inventive in lowering the fixed cost component in their total
costs. For instance, firms have made cost structures more flexible by:
- Negotiating labor contracts that emphasize flexibility and allow the firm to make
its labor costs more sensitive to its financial success - Entering into joint venture agreements, where the fixed costs are borne or shared
by someone else - Subcontracting manufacturing and outsourcing, which reduce the need for ex-
pensive plant and equipment
9 • 20 VALUATION IN EMERGING MARKETS