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Lesson 3 of 6 · 14 min
Estimating beta for the cost of equity
The CAPM turns a beta estimate into a company's cost of equity, so the analyst's choices in estimating beta (regression form, adjustment towards 1.0, index, horizon and return frequency) flow straight into the valuation.
In short
- The cost of equity (required return on equity) discounts FCFE directly and is the equity part of the WACC that discounts FCFF.
- At one point in time and in one country, and the MRP are the same for every stock, so in the CAPM only beta makes costs of equity differ. Over time all inputs move.
- Beta is estimated by regression: on excess returns on , or more simply with the market model on raw returns; both give similar slopes.
- Adjusted beta = × raw beta + × 1.0, commonly and : it pulls the estimate towards 1.0 because betas mean-revert.
- Practical choices: which index is the market, how noisy the estimate is (low , high standard error), and the horizon and frequency of returns (about 100 weekly returns over two years is a common default).
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