The stock market bubble might have burst, but the memory lingers. One pernicious aftereffect of the rise and fall in the valuations of telecommunications, media, and technology shares is a continuing distortion of the risk metrics that companies use—for example, to estimate their cost of capital. Unless they correct for this bias, their executives could overvalue investment and acquisition opportunities and overestimate their companies’ historical financial performance.
Most companies estimate their cost of capital using the capital asset-pricing model,1 in which the nondiversifiable risk of a company is measured by calculating the way its stock price moves, both in speed and volatility, in relation to market indexes. The resulting measure is known as a beta, which is greater than 1.0 if a stock moves, over time, ahead of the market (and is therefore riskier) and less than 1.0 if it tends to move behind the market. A beta of 1.5 foretells a 1.5 percent change in an asset’s return for every 1 percent change in the market’s return. The higher the beta, it is argued, the higher the cost of capital.
Despite volatility in the market during the 20 years before 1998, industry-specific betas—as opposed to the betas...