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How market beta can make hurdle rates look artificially low.
Don Durfee, CFO Magazine
November 1, 2006
During the late 1990s, something odd happened to businesses outside of the roaring tech and media industries. They saw their cost of capital decline by as much as two or three percentage points. The lower cost of capital seemed to suggest that these businesses were less risky than before.
Yet nothing about these businesses had really changed. The culprit, according to new research from McKinsey, was the beta, the measure of stock-price volatility that companies use to calculate their cost of capital. Cost of capital, in turn, is used to determine a firm's hurdle rate, the minimum expected return that managers will accept before approving a new project. Oldline businesses, such as manufacturers and chemical companies, saw their betas drop from about 1.0 to 0.6 between 1998 and 2001.
Why the change? Beta measures the riskiness of a single stock relative to the entire market. As a result, there are two reasons it might decline at one company — either the company's stock price fluctuates less, or the rest of the market zigs and zags more. During the dot-com boom and bust, the market was to blame. Dominated by technology stocks, the whole market became more volatile.
The effect can be misleading. Companies that cut hurdle rates based on falling betas wound up approving investments that they should have stopped. Still, says Marc Goedhart, one of the authors of the study, many of the CFOs he worked with didn't automatically cut hurdle rates in response to their falling betas — the figures were just too low.
Non-tech betas have now returned to their historical levels. The lesson, contends Goedhart, is to watch out for relative measures like beta. "It's a backward-looking estimate," he says. "Ordinarily that works fine. But if your beta falls almost to the level of the beta for government bonds, you need to take a closer look." In short, just because the market has become more risky doesn't necessarily mean your business has become more secure.