3.7.1 Problems with using industry comparisons to estimate business risk and beta value
It can be difficult to estimate the beta that a project should have as it is difficult to find other companies which are a close match in business risk to the project under appraisal on account of differences in their operations, finances and strategic positions. Or to put it another way, the risk attributed to a company is not solely determined by what industry it is in. Many other factors come into play and all of these will affect its beta.
For example, companies used for the industry comparison may:
- sell different products
- vary in size
- vary in the balance of fixed and variable costs (operating gearing)
- vary in the capability and reputation of management
- operate in different industries as well as the one for the project being considered
- vary in potential for future growth or decline
- more generally, vary in their strategic position, as identified through techniques such as PESTEL and SWOT analysis.
One pragmatic (if not optimal) solution when using the CAPM is to assume that on average, things balance out, and that the average beta of companies operating in the relevant industry is a good estimate for the correct beta the company should use when appraising its own project in that industry. (However, note that if the company doing the project appraisal does systematically differ from other companies on the above factors, it is possible that the beta it should apply when appraising the project should be different from the industry average. This is a complicated issue which is beyond the scope of this course.)
Arguably, the expected returns from a company entering a new market should also be higher than those the market expects from a company which is already established in a market. This is because entering a new market is intrinsically more risky than continuing to operate in one.