Aswath Damodaran – Session 8 (MBA): Determinants of Betas


Aswath Damodaran – Session 8 (MBA): Determinants of Betas

 

Published on Mar 1, 2016

We started class today by connecting the three pieces that we have talked about so far in class, the risk free rate, the equity risk premium and beta to an expected return and how that expected return becomes a cost of equity. We spent the rest of the class talking about the determinants of betas. Before we do that, though, there is one point worth emphasizing. Betas measure only non-diversifiable or market risk and not total risk (explaining why Harmony can have a negative beta and Philip Morris a very low beta).

1. Betas are determined in large part by the nature of your business. Products and services with elastic demand should have higher betas than products with inelastic demand. And if you do get a chance, try to make that walk down Fifth Avenue…
2. Your cost structure matters. The more fixed costs you have as a firm, the more sensitive your operating income becomes to changes in your revenues.
3. Financial leverage: When you borrow money, you create a fixed cost (interest expenses) that makes your equity earnings more volatile. Thus, the equity beta in a safe business can be outlandishly high if has lots of debt.
I also introduced the notion of betas being weighted averages with the Disney – Cap Cities example.
Slides: http://www.stern.nyu.edu/~adamodar/po…
Post class test: http://www.stern.nyu.edu/~adamodar/pd…
Post class test solution: http://www.stern.nyu.edu/~adamodar/pd…

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About the Author

Aswath Damodaran
Please note that I do not read comments posted here, nor respond to messages here. I don't have the time. If you want my attention, you must seek it directly at my blog. Aswath Damodaran is the Kerschner Family Chair Professor of Finance at the Stern School of Business at New York University. He teaches the corporate finance and equity valuation courses in the MBA program. He received his MBA and Ph.D from the University of California at Los Angeles. His research interests lie in valuation, portfolio management and applied corporate finance. He has written three books on equity valuation (Damodaran on Valuation, Investment Valuation, The Dark Side of Valuation) and two on corporate finance (Corporate Finance: Theory and Practice, Applied Corporate Finance: A User’s Manual). He has co-edited a book on investment management with Peter Bernstein (Investment Management) and has a book on investment philosophies (Investment Philosophies). His newest book on portfolio management is titled Investment Fables and was released in 2004. His latest book is on the relationship between risk and value, and takes a big picture view of how businesses should deal with risk, and was published in 2007. He was a visiting lecturer at the University of California, Berkeley, from 1984 to 1986, where he received the Earl Cheit Outstanding Teaching Award in 1985. He has been at NYU since 1986, received the Stern School of Business Excellence in Teaching Award (awarded by the graduating class) in 1988, 1991, 1992, 1999, 2001, 2007, 2008 and 2009, and was the youngest winner of the University-wide Distinguished Teaching Award (in 1990). He was profiled in Business Week as one of the top twelve business school professors in the United States in 1994.