In finance, Beta measures the volatility of a stock compared to the overall market. However, when we look deeper into Beta, we encounter two different versions: Levered Beta and Unlevered Beta. These two types of beta allow us to assess a company's risk profile depending on whether or not it includes the impact of financial leverage (debt).

1. Levered Beta (Equity Beta)

Levered Beta, also known as Equity Beta, measures the volatility of a company’s equity relative to the market while accounting for the effect of debt. It includes both the risks associated with the company’s operations (business risk) and the risks associated with the company’s capital structure (financial risk).

The more debt a company has, the riskier its equity becomes, which in turn increases the levered beta. This is because debt amplifies the effects of business fluctuations—higher debt levels lead to higher financial risk, thus causing greater volatility in the returns to equity holders.

  Levered Beta (βL) = Unlevered Beta (βU) * [1 + (1 - Tax Rate) * (Debt/Equity)]

  Where:

  - βL = Levered Beta

  - βU = Unlevered Beta

  - Tax Rate = Corporate tax rate

  - Debt/Equity = Ratio of debt to equity in the company’s capital structure

2. Unlevered Beta (Asset Beta)

Unlevered Beta, also known as Asset Beta, measures the volatility of a company’s assets without considering the effects of leverage. It reflects the business risk of the company, independent of how the company is financed. By removing the impact of debt, unlevered beta provides a clearer view of the risk inherent in the company’s core operations.

Unlevered Beta is particularly useful for comparing companies across different capital structures, as it allows investors to assess the underlying business risk without the distortion created by varying levels of debt.

  Unlevered Beta (βU) = Levered Beta (βL) / [1 + (1 - Tax Rate) * (Debt/Equity)]

Levered Beta considers both business risk and financial risk. It’s relevant for equity investors because it shows how the presence of debt affects the volatility of their investment.

Unlevered Beta only accounts for business risk, making it useful for assessing the core risk of the company’s operations without the influence of its capital structure.

Sometimes you may also hear about Adjusted Beta. This is a beta value that has been modified to account for the typical tendency of beta to revert towards the market average over time. Adjusted Beta is often used by analysts and investors to provide a more realistic assessment of future risk. A common method to calculate Adjusted Beta is by using the Blume Adjustment:

- Adjusted Beta = (2/3 * Levered Beta) + (1/3 * 1.0)

The idea behind this adjustment is that, over time, a company's beta is likely to trend towards the market beta of 1. Thus, Adjusted Beta is a weighted average of the calculated Levered Beta and the market beta of 1.

Let’s consider an example to understand how Levered and Unlevered Beta are used:

Company A has a Levered Beta of 1.5, a debt-to-equity ratio of 0.5, and a corporate tax rate of 30%. We want to calculate the Unlevered Beta.

  Unlevered Beta (βU) = 1.5 / [1 + (1 - 0.3) * 0.5]

  Unlevered Beta (βU) = 1.5 / [1 + 0.7 * 0.5]

  Unlevered Beta (βU) = 1.5 / 1.35 = 1.11

 
In this example, the Unlevered Beta of 1.11 represents the risk associated with Company A’s core operations, excluding the impact of financial leverage.

Levered Beta is used when you are looking at the risk from an equity investor’s perspective. It gives a sense of how much the company's stock is expected to move in relation to the market, taking into account both operational and financial risks.

Unlevered Beta is useful when comparing companies with different capital structures or when valuing a company with no existing debt. It provides a pure measure of business risk.

   - Beta is a crucial component of the CAPM, which is used to calculate the Cost of Equity. Depending on the situation, either Levered or Unlevered Beta is used.

   - For example, if you’re valuing a firm with no leverage, you would use Unlevered Beta to determine the cost of equity.

   - When valuing private companies, you may need to estimate the beta by looking at comparable publicly traded companies. In such cases, you first unlever the betas of the comparables to remove the effect of their leverage, then re-lever the beta based on the target company's desired capital structure.

   - Levered Beta gives equity investors a sense of the overall risk of holding the company’s stock, considering both business and financial risks.

   - Unlevered Beta helps in understanding the underlying risk of the business itself, without the influence of debt.

Levered Beta and Unlevered Beta are both vital tools in understanding the risk associated with a company. Levered Beta includes the impact of financial leverage and is essential for equity investors, while Unlevered Beta isolates the core business risk, making it useful for cross-company comparisons. Adjusted Beta provides a more refined measure, recognizing that a company's beta tends to revert to the market average over time. Together, these metrics help investors and analysts make informed decisions about the risks and potential returns of an investment.