Estimating the CAPM Beta for Public and Private Firms: Challenges and Solutions

Estimating the CAPM Beta for Public and Private Firms: Challenges and Solutions

Luis Javier Sanchez-Barrios (Universidad del Norte, Colombia), Benedicto Kulwizira Lukanima (Universidad del Norte, Colombia), Natalia Hernandez-Vargas (Universidad del Norte, Colombia) and Luis Ricardo Almanza Herazo (Universidad del Norte, Colombia)
Copyright: © 2020 |Pages: 27
DOI: 10.4018/978-1-7998-1086-5.ch006

Abstract

This chapter presents solutions to some challenges when calculating CAPM Beta. Three methods for calculating traditional beta are presented and illustrated through the case of Facebook. Different choices of market index, data frequency, and sample size result in different values of beta; however, in all cases beta was greater than one. The chapter explores ordinal beta as an alternative measure to treat outliers in both developed and thin markets. Using a sample of 84 US stocks, there was no statistical difference between median traditional and ordinal betas. This was not the case for a sample of 47 Colombian stocks, which questions the usefulness of traditional beta in thin markets. In contrast with median traditional beta, median ordinal beta did not change significantly as a result of irregular data series. The contrary occurred when the observation (sampling) period was reduced; this leaves open the question of subjectivity when defining such period. Finally, the process of valuing a private company was illustrated through the case of Palmoil Ltd., a Colombian company.
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Introduction

Beta is one of the vital variables in company valuation. It is a component to calculate the cost of equity within the Capital Asset Pricing Model (CAPM). However, estimating beta has become among the challenging issues due to lack of universal criteria in determining the estimation variables such as: historical sample size, data frequency, outliers and portfolio market returns. In this chapter, an attempt is made to outline and discuss these challenges and suggest some possible remedies for both public and private companies.

The chapter does not intend to reach conclusions about solutions to the challenges. Instead, it extends the existing debates in the literature on practical issues to be considered in order to overcome the estimation challenges. Specifically, these practical challenges are addressed contextually, utilizing real company cases as well as taking into account contrasting circumstances between developed markets and thin markets (emerging markets or infant markets). The chapter focuses on the following specific aspects:

  • 1.

    It gives a brief theoretical background of the CAPM, its practical limitations and the role of beta.

  • 2.

    Second, it describes the general procedure in estimating CAPM beta, with specific emphasis on data requirements, challenges and possible solutions. On this aspect a clear distinction is made between practical problems in developed markets and emerging markets. Here, the US is used to represent developed markets, whereas Colombia represents thin markets.

  • 3.

    It addresses the issues of outliers by introducing an alternative beta estimate, hereafter referred to as ordinal beta. In this aspect, a contrasting analysis is made between the traditional CAPM beta and the ordinal beta, focusing on their suitability in developed markets and thin markets.

  • 4.

    It presents a method of estimating beta for private companies based on beta of comparable public companies, while highlighting limitations and solutions.

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