The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, or the general dangers of investing, and the expected return on assets, particularly stocks. The CAPM was developed as a way to measure this systematic risk. Let's see what the CAPM is, how it is calculated and what factors we should take into account when using it.
What is the Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, or the general dangers of the investment, and the expected return on the assets, particularly stocks. Translated into Spanish it means capital asset pricing model. It is a financial model that establishes a linear relationship between the return required for an investment and the risk. The model is based on the relationship between the beta of an asset, the risk-free rate (usually the bond rate) and the equity risk premium, or the expected market return minus the risk-free rate. The CAPM was developed as a way to measure this systematic risk. It is widely used in finance for pricing risky securities y generate expected returns on assets, given the risk of those assets and the cost of capital.
How is the CAPM calculated?
The objective of the CAPM formula is assess whether a stock has a fair value when its risk and time value of money are compared to its expected return. In other words, by knowing each of the parts of the CAPM, it is possible to gauge whether the current price of a stock is consistent with its probable profitability. The beta coefficient of an investment is the measure of how much risk an investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a stock has a beta less than one, the formula assumes that it will reduce the risk of a portfolio. The beta of a security is multiplied by the market risk premium, which is the expected market return above the risk-free rate. The risk-free rate is added to the product of the security's beta y the market risk premium. The result should give an investor the required profitability or the discount rate which you can use to find the value of an asset. The formula to calculate the expected return of an asset, given its risk, is the following:
CAPM formula and legend.
Example of use of the CAPM
For example, let's imagine that we are considering investing in a stock valued today at $100/share that pays an annual dividend of 3%. Let's say this stock has a market beta of 1,3, which means it is more volatile than a broad market portfolio (i.e., the S&P 500 Index). Let's also assume that the risk-free rate is 3% and that we expect the market to appreciate 8% per year. The expected return on the stock according to the CAPM formula it is 9,5%:
Calculation of the example next to the CAPM formula.
The expected profitability of the CAPM formula is used to discount expected dividends and capital appreciation of the stock over the expected holding period. If the discounted value of those future cash flows is equal to 100 dollars, the CAPM formula indicates that the action has a fair value in relation to the risk.
Problems with CAPM
In a general framework, we can find two main factors that can cause problems when valuing shares:
Unrealistic assumptions:
It has been shown that different assumptions on which the CAPM formula is based do not correspond to reality. Modern financial theory is based on two assumptions:
- Stock markets are very competitive and efficient, that is, the relevant information about the companies distributes and absorbs quickly and universally. These markets are dominated by Rational risk-averse investors, What do they seek maximize satisfying returns on your investments.
- The inclusion of beta in the formula means that Risk can be measured by the volatility of a stock's price. However, price movements in both directions are not equally risky. The look back period for Determining the volatility of a stock is not standard because stock returns (and risk) are not normally distributed.
Estimation of risk premium:
The market portfolio used to find the market risk premium It is only a theoretical value and is not an asset that can be purchased or invested in. as an alternative to shares. Most of the time, investors use a major stock index, such as the S&P 500, to proxy for the market, which is an imperfect comparison. The most notable criticism of the CAPM is the assumption that future cash flows can be estimated for the discounting process. If an investor could estimate the future profitability of a stock with a high level of precision, the CAPM would not be necessary.