With investing, the higher the risk, the more an investor expects to earn. The capital asset pricing model (CAPM) tries to estimate how much you can expect to earn given the amount of risk. The model is often used in conjunction with fundamental analysis, technical analysis and other methods of sizing up securities when making investment decisions. But many investment professionals warn that CAPM should not be used to calculate the expected return of equity shares because it does not account for the real volatility of the stock market. Let’s break down the formula and consider whether investors should use it to determine the risk of an investment.
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Investors use CAPM when they want to assess the fair value of a stock. So when the level of risk changes, or other factors in the market make an investment riskier, they will use the formula to help re-determine pricing and forecasting for expected returns.
One common example where you might need to reassess pricing and returns is when interest rates change. At the moment of writing this article in March 2021, many investors are concerned about rates going up.
Depending on whether they go up or down, the direction of interest rates can make borrowing money more expensive or cheaper. And this in turn will have a rippling effect on the value of stock and the rate of return that investors expect to get from their investment.
Assuming that rates go up, borrowing money becomes more expensive, which could ultimately raise a company’s cost of capital, eat away at profits and cash flow, and increase the rate of return that investors will demand for taking a bigger risk on the company.
Thiswill drive down the stock value of a company, or raise it when interest rates fall if the rippling effect remains constant in the other direction. In either case, you may likely want to re-determine the fair value of a stock to re-assess whether the risk is still worth taking.
Let’s take a look at how CAPM is calculated.
Understanding the Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM) is widely used within the financial industry, especially for riskier investments. The model is based on the idea that investors should gain higher yields when investing in more high-risk investments, hence the presence of the market risk premium in the model’s formula.
Expected return = Risk-free rate + (beta x market risk premium)
Using the capital asset pricing model, the expected return is what an investor can expect to earn on an investment over the life of that investment. It is a discount rate an investor can use in determining the value of an investment. The risk-free rate is the equivalent of the yield of a 10-year U.S government bond, though if the calculation is being done in another country, it should use that government’s 10-year bond yield.
Beta is the representation of a stock’s risk, a numerical value that quantifies how susceptible the stock is to changes in the market. If a stock’s risk outpaces the market, its beta is more than one. If its beta is less than one, it can reduce the risk within a diversified portfolio.
Lastly, the market risk premium represents an asset’s return beyond just the risk-free rate. The market risk premium is an added return that can entice investors to put capital into riskier investments.
Risky investments can be worthwhile to investors if the return rewards them for their time and risk tolerance. The goal of CAPM is to evaluate whether or not a stock’s value is worth that risk.
Breaking Down the CAPM Formula
Imagine that you are looking at a stock worth $50 per share today and it pays a 3% annual dividend. The stock’s beta is 1.5, making it riskier than the overall market. Also, assume that the risk-free rate is 3% and this investor expects the market to rise in value by 5% per year.
The expected return of the stock based on CAPM is 6%.
That expected return discounts the stock’s expected dividends and appreciation of the stock over the expected holding period. If the discounted value of future cash flows is equal to $50, CAPM says the stock has a fair price for its risk.
History of CAPM
William Sharpe, an economist and Nobel laureate devised CAPM for his 1970 book “Portfolio Theory and Capital Markets.” He notes that an individual investment contains two kinds of risk:
Unsystematic risk, or specific risk is what modern portfolio theory targets when it suggests diversification of a portfolio. However, diversification doesn’t address systematic risk. CAPM exists for measuring systematic risk.
Pros and Cons of CAPM
The capital asset pricing model is important in the world of financial modeling for a few key reasons. Firstly, by helping investors calculate the expected return on an investment, it helps determine how appropriate a particular investment may be. Investors can use the CAPM for gauging their portfolio’s health and rebalancing, if necessary.
Secondly, it’s a relatively simple formula that’s fairly easy to use. Additionally, the CAPM is an important tool for investors when it comes to accessing both risk and reward. It’s also one of the few formulas that accounts for systematic risk.
That said, CAPM’s critics say it makes unrealistic assumptions. For instance, beta doesn’t acknowledge that price swings in either direction don’t hold equal risk. And, using a particular period for risk assessment ignores that risk and returns don’t distribute evenly over time.
The CAPM also presupposes a constant risk-free rate, which isn’t always the case. A 1% bump in treasury bond interest rates would significantly affect that investment. Meanwhile, using a stock index like the S&P 500 only suggests a theoretical value. That index could perform differently over time.
While the capital asset pricing model isn’t without its downfalls, investors continue to use the formula in combination with othermethods of sizing up securities to make investment decisions. If you intend to use CAPM to help you determine whether an investment is worth the risk, experts say that the formula does not account for the real volatility of the stock market. So you should keep in mind that risk and returns don’t distribute evenly over time.
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