Demystifying a Company’s Systematic Risk
The Michel-Shaked Group’s Israel Shaked and Brad Orelowitz published an article in the February 2022 issue of the American Bankruptcy Institute Journal discussing beta, the measure of a company’s systematic risk, and its application to valuation. Specifically, they discussed how to calculate beta, cases where the calculation of beta may require further analysis, and used examples of retail valuations in the context of bankruptcy litigation.
A common methodology employed by valuation professionals is the discounted cash flow (DCF) method. If this methodology is applied, the valuation professional must calculate the present value of projected cash flows which requires them to determine a discount rate. The discount rate has two components: the cost of debt and the cost of equity. The Capital Asset Pricing Model is typically utilized to calculate the cost of equity and one of its key components is the beta, which measures the historical volatility of a company’s stock price relative to the volatility of the overall market.
The article discussed valuation situations where the determination of beta may require extra attention. Israel and Brad articulated why in certain situations, such as for private companies, recent IPOs, and highly distressed companies, it may not be possible or meaningful to simply run a regression to calculate beta.
Using their recent experience as expert witnesses in the Neiman Marcus, J. Crew, Tailored Brands and Chesapeake Energy bankruptcies, Israel and Brad describe that abnormal market activity caused by unforeseen events (such as the COVID-19 pandemic) can require use of a normalized beta to calculate an appropriate discount rate. Betas of companies and their peers during the height of the COVID-19 pandemic did not properly represent the typical volatility under otherwise normal market conditions.
A full version of this article can be seen here.