A basic assumption of valuation is that risk is negatively correlated to value. However, what sort of risk is relevant to valuation? The risk that matters to holders of a financial asset is the risk that the underlying cash flows generated by that asset will not be forthcoming. Thus, the volatility of those cash flows, as well as the probability that the cash flows will be below some critical level, are determinants of the risk. Unfortunately, the most common proxy for risk in valuation analysis is the statistical artifact, beta. Beta is the slope of the ordinary least squares regression relating returns of a security to returns from the market as a whole (as typically proxied by the S & P 500). This regression beta does not measure the fundamental risk that is described above, that is the risk that cash flows will not meet expectations. An alternative to the statistical beta would be to use a beta that is based on fundamental factors driving risks to cash flows. This alternative beta, described as a fundamental beta, can be used to determine a company's beta for purposes of valuing its stocks or bonds or the company as a whole (as might be required when another company considers merging with or acquiring this firm). The fundamental beta is a function of company size (smaller firms are assumed to have more unpredictable future cash flows and thus higher betas than larger firms), the degree of operating leverage (higher operating leverage means more volatility in cash flows and thus higher betas), the elasticity of demand for its products (more elastic demand translates into higher beta, more inelastic demand translates into lower beta), the degree of market competition faced by the firm (more competition results in greater uncertainties for future cash flows and thus higher betas), and the amount of financial leverage (more financial leverage means higher betas).
 
 

What are the problems with trying to estimate and use a fundamental beta?

What about political factors? How might we incorporate political factors into fundamental betas?
 
 

How are betas used in estimating the weighted average cost of capital?