What factors determine the beta of an equity?

The three factors that influence beta are a) Cyclicality of revenues, b) Financial leverage, and c) Operating leverage. Firms have cyclic revenues if their revenues go up and down with the seasons or in cyclic manner. Firms with a high financial leverage have high levels of debt in their capital structure and firms with high operating leverage have high levels of fixed costs to variable costs. Beta measures the responsiveness of a securitys returns to movements in the market.

Beta is determined by the cyclicality of a firms revenues. This cyclicality is magnified by the firms operating and financial leverage. The following three factors will impact the firms beta. (1) Revenues. The cyclicality of a firms sales is an important factor in determining beta. In general, stock prices will rise when the economy expands and will fall when the economy contracts. As we said above, beta measures the responsiveness of a securitys returns to movements in the market. Therefore, firms whose revenues are more responsive to movements in the economy will generally have higher betas than firms with less-cyclical revenues.

(2) Operating leverage. Operating leverage is the percentage change in earnings before interest and taxes (EBIT) for a percentage change in sales. A firm with high operating leverage will have greater fluctuations in EBIT for a change in sales than a firm with low operating leverage. In this way, operating leverage magnifies the cyclicality of a firms revenues, leading to a higher beta. (3) Financial leverage. Financial leverage arises from the use of debt in the firms capital structure. A levered firm must make fixed interest payments regardless of its revenues. The effect of financial leverage on beta is analogous to the effect of operating leverage on beta. Fixed interest payments cause the percentage change in net income to be greater than the percentage change in EBIT, magnifying the cyclicality of a firms revenues. Thus, returns on highly-levered stocks should be more responsive to movements in the market than the returns on stocks with little or no debt in their capital structure.