The Capital Asset Pricing Model (CAPM) is a way to measure the cost of equity of a firm and the expected returns from an investment.
TABLE OF CONTENTS:
The Capital Asset Pricing Model explained.
Investments come with risk, the higher the return the higher the risk. The CAPM model helps establish the relationship between the expected return and the systematic risk of the company.
Therefore, CAPM model helps to measure systematic risk that a company or investor cannot avoid and therefore is used by both parties. Companies have two sources of raising capital, equity, and debt. That’s why managers compare the cost of equity to the cost of debt when considering investment and capital allocation strategies.
When plotted on a chart, CAPM shows the relationship between the expected return and trade-off concerning risk. It implies the returns expected rise in tandem the more risk an investor takes. In the above diagram we have used a Beta of 1.
An investor will use the Capital Asset Pricing Model to determine if the theoretical return on the investment is in their favour considering the risk involved. The model is measured against the risk-free rate (a safe zero-risk instrument) and the Market Return (Risk Premium).
If an investor puts money into a risky stock, they need higher risk premiums (rate of return) in exchange. The CAPM model helps investors determine how much they can expect to get back for the investment and creates a better understanding of the risk/reward payoff.
Cost of Equity
The Cost of Equity is an important component of measuring the Weighted Average Cost of Capital for a business. To calculate the WACC we use both the Cost of Equity and the Cost of Debt to determine the firm’s cost of capital and best way to raise capital in the future. The equity of a public company is made up of the common shares and preferred shares. You as a shareholder are an “equity” owner.
Investors in the financial sector and investment banking often use the Cost of Equity to estimate the fair value of an asset. Using the CAPM helps them to determine the cost of equity on a potential investment, which answers two questions: 1) What is the riskiness of this company compared to the market? 2) What return on my capital can I expect for taking on this risk?
If the risk isn’t worth it, investors can opt for a Risk-Free option like a 10-year Government Bond. Alternatively, if the payoff isn’t satisfactory, they can hold an index fund or an ETF and take on the Market Risk without the individual company risk.
The CAPM model is based on theoretical returns and helps investors make decisions. Therefore, cost of equity is simply a calculation that says, “If this company delivers on its strategy, taking into account the risk, then it should provide investors with X% return.” However, it doesn’t guarantee the return.
Managers, especially those with wise capital allocation skills, pay close attention to the Cost of Equity and the cost of debt. If a company can secure funding through bonds or the bank at 2.5%, why would it raise capital through equity markets at 10%?
What is the CAPM formula?
- Cost of Equity = Risk-Free Rate + Beta x (Market Risk – Risk-Free Rate)
- rf = Risk-Free Rate
- Ξ² = Beta
- mr = Market Return
- rp = Risk Premium
Risk-Free Rate
The Risk-Free Rate is a theoretical interest rate of return that carries zero risk. Although technically all investments carry some level of risk, investors want a way to measure the rate of return against other safer alternatives to ensure that the payoff to risk-reward is in their favour.
Ξ² – Beta
The Beta is a measure of the volatility (systematic risk) of a stock compared to the broader market. A stock with a beta of 1.0 displays the same volatility as the market such as the S&P 500 or the ASX 200. A beta less than 1.0 indicates a stock is less volatile than the market. A beta greater than 1.0 indicates a stock is more volatile than the market. If a company has a beta of 1.8 the stock has 180% of the volatility of the market average.
Market Return
The Market return is the return of the market as a whole or on a market index like the S&P 500 or the ASX 200. It is the average return of holding a basket of funds often through diversification. The market return creates the foundation for the Beta and how a company moves in tandem with the market.
Risk Premium
The Risk Premium (RP) is the additional rate of return that investors expect to receive for taking on more risk when investing in stocks. This premium is above the Risk-Free Rate, which is the return that investors expect from a risk-free investment.
How to use the Capital Asset Pricing Model?
We will now go through a complete example to demonstrate how we can determine the Cost of Equity for an Australian company. To calculate the Risk-Free Rate, we will use the Australia Bond 10 Year Yield, the S&P/ASX 300 10-Year average return and the company’s Beta.
It’s worth noting that the company’s Beta can differ from one website to another. Therefore, we recommend taking two different Betas from reputable websites and then calculating the average. This method may not make sense for companies that show a similiar beta across sites. However, if one website provides a beta of 1.2 and another of 1.5, there is a 30% volatility variance.
Let’s start with the Risk-Free rate. Taken from Bloomberg.
Then we want to know the Market Average return for the ASX 300 which is as below. The Information from S&P Global showing the Total return of the market.
We then find the average Beta from two financial websites such as Yahoo Finance. The Beta of our chosen company is 1.38. Now let’s put it all together and see what we come up with for the Cost of Equity.
| CAPM | Inputs |
|---|---|
| Risk-Free Rate (10-year Govt Bond) | 4.01% |
| Beta (The risk against the market) | 1.38 |
| Market Return (Taken as the ASX 300 10-Year) | 8.02% |
| Risk Premium (Market Return – Risk-Free Rate) | 4.01% |
| Cost of Equity % | 9.54% |
Our calculation looks like the below.
Expected Return = 4.01 + 1.38 x (8.02- 4.01) = 9.54%
What this is telling investors is for the risk reflected in this investment they can expect a theoretical 9.54% return on their investment.
The Cost of Equity will rise along with the Beta, as the systematic risk corresponds with a higher return. Conversely, a low Beta will present a lower expected return.
Advantages and Disadvantages of using the CAPM model?
The Capital Asset Pricing Model (CAPM) is a widely used financial model for calculating an asset’s expected return based on its risk level. However, there are some issues with this model. One of the main problems is that the data used in CAPM can change dramatically, which can lead to an incorrect “theoretical return”.
Market returns, risk-free rates, and beta can all fluctuate, making it challenging to predict an accurate rate of return.
Furthermore, the beta is based on historical results, which is not forward-looking and may not be an accurate indicator of risk in general. The market risk premium is also a theoretical value that may not always hold true in reality. Essentially, when using CAPM, we assume that all things will move in complete unison, which is not always the case in the real world.
Another issue with CAPM is that it only considers systematic risk and focuses on single-period timelines based on the past. It does not take into account unforeseen events or changes in the market that could impact the rate of return.
Finally, CAPM is based on assumptions and should be used as a guide rather than an “all-in” approach. It’s important to remember that markets, companies, and investments are constantly changing, and CAPM may not always accurately predict returns.
In Summary…
I frequently use the CAPM for two reasons: to determine the Cost of Equity in the WACC formula and to use it as my Discount Rate. Unlike some investors that use a discount rate in line with the risk-free rate, I prefer to use the cost of equity, as I find it more logical.
Cost of equity and the WACC are fundamental to valuation and modelling work such as the Discounted Cash Flow Model. When we analyse a company, we are essentially discounting the future cash flow back to today’s present value. Therefore, it makes sense to use the cost of equity for the company we are valuing as the discount rate.
In simpler terms, let’s say we have a Cost of Equity of 10%, which we use as our discount rate. If all our assumptions are correct and everything goes according to plan, we should technically get the expected return that we calculated. If the discounted share price is in line with the current share price, it is considered fair value, and holding it annually should provide a 10% return.
This is all theoretical, of course. π
Why do I say this? As logical investors, we cannot be so rigid or blinded by the formulas or intellectual stimulation by complex calculations. Whilst I use a lot of these formulas, they make up only a fraction of how I view, research, and take positions in companies.
We cannot delve into complex financial metrics too much. I believe it can create βanalysis paralysisβ and stop investors from seeing the bigger picture and thinking differently about companies and the fundamentals that drive the engine of that business.
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