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

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…