Module II· Cost of Equity & CAPMIntermediate
Question
What is 'beta de-smoothing', and when do you need it?
Answer
Mechanics
For thinly traded or illiquid stocks (small mid- and small-cap names, illiquid small caps), beta tends to be underestimated — the stock reacts to market moves with a lag.
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Consequence
Raw beta artificially low (e.g. 0.6 instead of a realistic 0.9). De-smoothing:
- Dimson beta: regress on current and lagged returns, then sum the coefficients.
- Sum beta: beta + lag-1 beta. In practice: for large- and mid-caps rarely needed. For small-caps, micro-cap segments, or middle-market names it can make a 0.2–0.3 difference in beta. In an IB pitch: mostly ignored, but relevant for middle-market comp sets.