What drives the 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 business

The entire economy goes through business cycles. Businesses behave differently with business cycles. Some companies’ earnings fluctuate more with business cycles. Your earnings grow during the growth phase of the business cycle and decline during the contraction phase.

For example, the profits 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, the profits of the utilities companies remind that they are not affected by the economic cycle. If we regress 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. The actual 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 trading conditions, it is likely to have a higher beta.

We must distinguish between earnings variability and earnings on a cyclical basis. A company’s earnings can be highly variable, but they may not have a high beta. The variability of earnings is an example of a specific risk that can be diversified. On the other hand, cyclically of a company’s earnings, it is the variability of its earnings compared to 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 profit before interest and taxes due to the change in sales. Since variable costs change in the direct proportion of 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. If all else remains the same, 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 the 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 company’s earnings. Therefore, changes in interest 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 make after-tax earnings vary with changes in earnings before interest and taxes. Therefore, the degree of financial leverage is defined as the change in a company’s earnings after taxes due to the change in its earnings before interest and taxes. Since financial leverage increases the financial risk of the company, it will increase the beta of capital of the company in question.