The Capital Asset Pricing Model (CAPM) is a mathematic formula that intends to determine the appropriate cost of equity to be employed to discount future cash flows, in order to estimate their present value. It combines different referential rates such as the risk-free rate and the overall market rate, along with risk indicators, to identify the level of return an investor should demand from its capital.
What is CAPM?
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Valuation methods such as the Discounted Dividends model and the Discounted Cash Flow model, employ discount rates to estimate the present value of a future stream of cash flows, in order to determine the fair value of an ongoing business. Yet, determining how much an investor should expect from his investment in a certain venture is not an easy task. Different businesses have different levels of risk, and investors have to adjust their minimum expected return depending on how risky their investment is.
The Capital Asset Pricing Model (CAPM), intends to combine referential return rates with a risk metric in order to estimate which would be the appropriate cost of equity for a particular investment. Financial analysts employ the CAPM on a daily basis in order to value businesses by incorporating the resulting rate into their valuation models to calculate the fair value of a business, which allows them to identify potential investment opportunities coming from under or overvalued stocks currently available in the market.
Capital Asset Pricing Model (CAPM) Formula
The formula to estimate the cost of equity through the CAPM is:
ERi = Rf + βi (ERm – Rf)
CAPM Equation Components
ERi: Minimum rate of return for the investment being analyzed.
Rf: The current yield of the financial instrument considered as the risk-free asset.
βi: The Beta multiple of the investment, which indicates its volatility compared to the market’s referential rate.
ERm: The market’s expected or average return.
Additionally, the βi component can be calculated as follows:
βi = Covariance / Variance
Where:
Covariance: The degree in which the investment’s rate of return behaves compared to the overall market’s average return.
Variance: The degree of fluctuation of the market’s rate of return compared to its own average rate of return.
One of the key components that will determine the final ERi is this part of the formula (ERm – Rf), which is known as the risk premium. This premium is understood as the additional return expected from an investment that carries a higher risk than the risk-free asset.
CAPM Calculation Example
Earth Tires is a publicly traded company whose stocks are currently priced at $14.5 per share. The business is being targeted by a larger tire manufacturer that is aiming at expanding its product line by incorporating the portfolio of products that Earth Tires produces. In order to estimate the fair value of Earth Tires, the financial advisors working for the acquirer need to know how much they should expect as a minimum return from the investment in order to make sure it’s a profitable transaction.
The following information will be employed for the calculation:
Risk-Free Asset Yield (T-Bill): 1.99%
Market Average Return (Last 5 years): 5.50%
Beta: 1.12
By using this data, the financial advisors estimated the cost of equity for the transaction by using the Capital Asset Pricing Model:
ERi = 0.0199 + 1.12 (0.055 – 0.0199) = 0.059 or 5.9%
This will be the cost of equity that will be employed in the subsequent Weighted Average Cost of Capital calculation that the advisors will determine, in order to estimate the discount rate to be employed in the valuation models they will use.
Capital Asset Pricing Model (CAPM) Analysis
Understanding the nature of each of the components of the CAPM is essential to properly analyze its result. First, the risk-free rate. In the U.S., the current yield of T-Bills, which are government-backed securities that are considered virtually risk free, is commonly employed to estimate a minimum expected rate of return through the CAPM. Yet, other potential referential risk-free rates can be found for European markets.
On the other hand, the β component, is determined through a mathematical formula that measures the relationship between the average results of an individual stock compared to the overall market’s results in order to understand how much the investment’s return may deviate from the market average. The higher the β result, the higher the appraised risk of the particular investment. A high β will increase the minimum expected rate of return for the investment as investors will demand a higher return to undertake such higher risk.
Finally, the ERm component tracks the average rate of return of the market, which establishes how much investors expect to receive from instruments such as stocks or convertible securities. One tricky part of determining the appropriate ERm involves considering the nature of the stock or the investment being evaluated and assess the expected rate of return for stocks similar to it in nature. For example, a small-cap stock should not be modeled by using the overall market’s average rate of return, as the overall market may demand a lower rate, as risk is widespread. In this case, finding an index for small-cap stocks and employ the average rate of return of such index to model the appropriate minimum rate of return to be expected from the investment may be the right path to take.
CAPM Uses, Cautions, Pitfalls
While the Capital Asset Pricing Model is the referential go-to model to determine the cost of equity of investments in modern finance, it is not free of flaws. One of the main disadvantages of the CAPM is that it considers β as the ultimate measure of risk. The fact that β employs stock prices as the main data source to estimate a business’ risk, it fails to include many elements involved in what would be a more accurate risk analysis.
In this sense, the CAPM becomes more a technical analysis tool than a valuation tool. Yet, given the fact that there’s no other model that is as sound as the CAPM to estimate a company’s cost of capital, investors commonly model several different scenarios, using the CAPM as the main variable, to estimate how much the value of the business will fluctuate for different costs of capital.