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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, rfr_f 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 (ri−rf)(r_i - r_f) on (rm−rf)(r_m - r_f), or more simply with the market model on raw returns; both give similar slopes.
  • Adjusted beta = w1w_1 × raw beta + w2w_2 × 1.0, commonly 23\tfrac{2}{3} and 13\tfrac{1}{3}: it pulls the estimate towards 1.0 because betas mean-revert.
  • Practical choices: which index is the market, how noisy the estimate is (low R2R^2, 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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Estimating beta for the cost of equity · The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models