What drives variance and covariance? The variance and covariance and therefore the beta depend on three fundamental factors: the nature of the business, the operating leverage and the financial leverage. These factors are discussed below.
nature of the business
The entire economy goes through business cycles. Companies behave differently with economic cycles. Some companies’ earnings fluctuate more with economic cycles. Your earnings grow during the growth phase of the business cycle and decline during the downturn.
For example, the earnings of consumer products companies or cargo companies are tied to the business cycle and rise or fall with the business cycle. On the other hand, profits of utility companies are not affected by the business cycle. If we make a regression of the earnings of a company with the aggregate earnings of all the companies in the economy, we would obtain a sensitivity index, which we can call the accounting beta of the companies. Real or market beta is based on stock market returns rather than earnings. Accounting betas are significantly correlated with market betas.
This implies that if a company’s earnings are more sensitive to business conditions, it is likely to have a higher beta.
We must distinguish between earnings variability and cyclical earnings. A company’s earnings can be highly variable, but they may not have a high beta. Earnings variability is an example of a specific risk that can be diversified. A company’s earnings cyclical, on the other hand, is the variability of its earnings versus the aggregate earnings of the economy.
operating lever
Operating leverage refers to the use of fixed costs. The degree of operating leverage is defined as the change in an economy’s earnings before interest and taxes due to the change in sales. Since variable costs change in direct proportion to sales and fixed costs become constant, the variability in earnings before interest and taxes when sales change is caused by fixed costs.
The higher the fixed cost, the greater the variability in earnings before interest and taxes for a given change in sales. Other things being equal, companies with higher operating leverage are riskier.
Operating leverage intensifies the cyclical effect on a company’s earnings. As a consequence, companies with a higher degree of operating leverage have high betas.
Financial appeceament
Financial leverage refers to debt in a company’s capital structure. Companies with debt in the capital structure are called leveraged companies.
Interest payments on debt are set independently of the companies’ profits. Therefore, interest changes are fixed costs of debt financing. Fixed costs of operations result in operating leverage and cause earnings before interest and taxes to vary with changes in sales.
Similarly, fixed finance costs result in financial leverage and cause earnings after taxes to vary with changes in earnings before interest and taxes. Therefore, the degree of financial leverage is defined as the change in a company’s after-tax earnings due to the change in its earnings before interest and taxes. Since financial leverage increases the financial risk of the firm, it will increase the firm’s equity beta.