software. We could define the business as entertainment software and consider
only companies that primarily manufacture entertainment software to be com-
parable firms. We could go even further and define comparable firms as firms
manufacturing entertainment software with revenues similar to that of the com-
pany being analyzed. While there are benefits to narrowing the comparable firm
definition, there is a large cost. Each additional criterion added on to the defini-
tion of comparable will mean that fewer firms make the list and the savings in
standard error that comprise the biggest benefit to bottom-up betas become
smaller. A common sense principle should therefore come into play. If there are
hundreds of firms in a business, as there are in the software business, you can
afford to be more selective. If there are relatively few firms, not only do you
have to become less selective, you might have to broaden the definition of com-
parable to bring in other firms into the mix.- Estimating Betas.Once the comparable firms in a business have been defined,
you have to estimate the betas for these firms. While it would be best to estimate
the regressions for all of these firms against a common and well diversified eq-
uity index, it is usually easier to use service betas that are available for each of
these firms. These service betas may be estimated against different indices. For
instance, if you define your business to be global telecommunications and ob-
tain betas for global telecom firms from Bloomberg, these betas will be esti-
mated against their local indices. This is usually not a fatal problem, especially
with large samples, since errors in the estimates tend to average out. - Averaging Method.The average beta for the firms in the sector can be computed
in one of two ways. We could use market-weighted averages, but the savings in
standard error that we touted in the earlier section will be muted, especially if
there are one or two very large firms in the sample. We could estimate the sim-
ple average of the betas of the companies, thus weighting all betas equally. The
process weighs in the smallest firms in the sample disproportionately but the
savings in standard error are likely to be maximized. There is also the issue of
whether the firm being analyzed should be excluded from the group when com-
puting the average. While the answer is yes, there will make little or no differ-
ence in the final estimate if there are more than 15 or 20 comparable firms. - Controlling for differences.In essence, when we use betas from comparable
firms, we are assuming that all firms in the business are equally exposed to busi-
ness risk and have similar operating leverage. Note that the process of levering
and unlevering of betas allows us to control for differences in financial leverage.
If there are significant differences in operating leverage—cost structure—across
companies, the differences in operating leverage can be controlled for as well.
This would require that we estimate a business beta, where we take out the ef-
fects of operating leverage from the unlevered beta.
Note the similarity to the adjustment for financial leverage; the only difference is
that both fixed and variable costs are eligible for the tax deduction and the tax rate is
therefore no longer a factor. The business beta can then be relevered to reflect the dif-
ferences in operating leverage across firms.
Business betaUnlevered beta
1 11 tax rate 21 Fixed costs>Variable costs 29 • 24 VALUATION IN EMERGING MARKETS