What is the Capital Asset Pricing Model (CAPM)?
In short:
The Capital Asset Pricing Model (CAPM) is a risk/return model for calculating the expected return on an asset for a given amount of risk, (market-wide risk). More plainly, the Capital Asset Pricing Model allows an investor to calculate how much additional return they should expect for the additional amount of risk they are taking with a given investment.
Although CAPM is not the only risk/return model available, it is the most widely used risk/return model in finance given its relative simplicity yet flexibility. To calculate the expected return with CAPM, the risk-free rate is added to the product of the company beta multiplied by the market risk premium.
FORMULA:
In-depth:
The CAPM provides a formula for calculating expected return also called the discount rate. Being able to calculate the expected return is a crucial concept in investing. From a discount rate, an investor will be better able to judge if an investment is overvalued or undervalued as well as decide between opportunity costs. That is if an investor is presented with two companies they will be able to decide which offers a better potential return given its price.
Basic Example Calculation
From its basic formula, using CAPM to calculate an expected return is pretty straightforward. For example, say we are looking at a US company whose beta is currently 1.25. For the risk free rate, we can find it by looking at the current yield of the US 10 Year Treasury, let’s say it’s 1.09%. To calculate the market risk premium, we will subtract what rate we expect the market to perform at from our risk free rate. For our example, we could use 10% as this is the rate of return the S&P 500 has generally returned on average since the 1920s. Putting all of these together our capm formula looks as follows.
Expected Return = 1.09% + 1.25(10% – 1.09%)
Expected Return = 12.23%
Market Risk Premium = (10% – 1.09%)
Market Risk Premium = 8.91%
While the example above seems straightforward, in actuality calculating the discount rate is not as simple. The difficulty and advantage for an investor comes in with how each component of capm is calculated, mainly beta and market risk premium.
Market Risk Premium
What an investor calculates for market risk premium will heavily influence if they believe a company is overvalued or undervalued. Say we take the example above, instead of using the long-term average for market risk premium, we believe the more accurate value is 5.75%. Now or expected return falls to 8.28%, meaning we are willing to pay much more for a certain company.
Why are we willing to pay more? Take a company with $100 of cash flow, divide by the discount rate and the result that is found in the price an investor is willing to pay to ensure that rate of return.
Long-term MRP: $100/12.23% = $817.66
More Accurate MRP: $100/8.28% = $1207.72
Beta
Beta is another area of heavy debate, as the way it is calculated will change the value. The core aim of using beta is to calculate the “riskiness” that a company’s share price will deviate from the price of another benchmark. The trouble comes in with questions like what timeframe to use for calculating beta and which benchmark is the best to use for a given company. For example, using the US benchmark (S&P 500) for a company that has no connection to the US (does no business in the US) may not result in the best beta.
Similar to the example with market risk premium, small changes with beta can have a meaningful impact on what an investor is willing to pay for a company. Taking the original calculation for expected return, Expected Return = 1.09% + 1.25(10% – 1.09%), and changing how we calculate the beta could result in a beat of 1.02. Now our expected return is not 12.23% but 10.17%.
Assumptions for CAPM
By using the Capital Asset Pricing Model and investor is adopting several assumptions. The two primary are first, everyone has access to the same information, there are no transaction costs, and therefore finding inefficiencies in the market via valuation errors is not possible. Second, the marginal investor is well diversified. Since the marginal investor is well diversified they are only worried about the market risk the company brings to their portfolio, not firm-specific risk.
Marginal Investor
- The marginal investor is the investor most likely to be trading the company at any given point in time. Since they are the ones currently trading the company they are the ones who must make the most up-to-date decision on what the company is worth.
Additional Resources: What is Beta in Stocks
Where to find individual information: Stock Information