Mean Reversion Adjusted Betas Used in Business Valuation Practice: A Research Note

Journal of Business Economics: Volume 85, Issue 7 (2015), Page 759-792

Posted: 30 Aug 2013 Last revised: 18 Aug 2015

Date Written: October 2015

Abstract

A major concern in business valuation is how to derive a beta value that adequately represents the assessment of long-term risk for a company. Against this background Morningstar (2013), Bloomberg and Thomson Reuters recommend adjusting betas estimated for company valuation purposes (using \beta_{i}^{adj.}=.371 .635\beta_{i}^{raw} commonly named as the “\nicefrac{1}{3} \nicefrac{2}{3}-Adjustment”) to take into account research findings from Blume (1971) demonstrating that betas revert towards the mean value of one over time: Using theoretical analysis as well as a simulated data set reflecting real market patterns, we analyse the eligibility of this beta adjustment formula for company valuation practice. We show that derived adjustment formula coefficients are influenced by the variation of market returns, the length of the analysis period chosen, the measurement error for beta, as well as the distribution of true betas, quantifying the impact of all four elements, and confirm the regression to the mean fallacy interpretation as discussed by Friedman (1992), Quah (1993), Stigler (1996, 1997), and Barnett et al. (2004). We further demonstrate the biasing effect on company values when using the \nicefrac{1}{3} \nicefrac{2}{3}-Adjustment which is particularly intensified for small betas measured. Based on our analysis we conclude that the recommended \nicefrac{1}{3} \nicefrac{2}{3}-Adjustment as a justification for converging risk profiles lacks fundamental substance and, accordingly, its potential use in business valuation should be subject to critical consideration.

Keywords: Valuation, Sorting, Regression to the Mean, Mean Reversion, CAPM, Beta Adjustments, Beta

JEL Classification: M40, G30, G12, C22, C15, C13

Suggested Citation

Echterling, Fabian and Eierle, Brigitte, Mean Reversion Adjusted Betas Used in Business Valuation Practice: A Research Note (October 2015). Journal of Business Economics: Volume 85, Issue 7 (2015), Page 759-792, Available at SSRN: https://ssrn.com/abstract=2317913 or http://dx.doi.org/10.2139/ssrn.2317913

Fabian Echterling (Contact Author)

Deka Investment GmbH ( email )

Mainzer Landstrasse 16
Frankfurt am Main, 60325
Germany

Brigitte Eierle

University of Bamberg ( email )

Feldkirchenstraße 21
Bamberg, 96052
Germany
00499518632545 (Phone)

HOME PAGE: http://www.uni-bamberg.de/bwl-irwp/home/

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