Capital Asset Pricing Model (CAPM): Formula, Example, Use & Work

What is Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) shows how systematic risk, or the risks of trading in general, affects the expected return on assets, mostly stocks. The company’s equity capital cost is a significant issue that the financial manager has to figure out. However, figuring out the cost of equity is very challenging; the answer is often subjective, so it can’t always be used as a reliable standard. One of the best things about CAPM is that it can give you objective estimates of equity prices.

Geeky Takeaways:

• The capital asset pricing model (CAPM) calculates predicted returns based on capital costs and asset risk.
• The CAPM calculation requires the overall market rate of return, the stock’s beta value, and the risk-free rate.
• The CAPM has restrictions, such as agreeing on the rate of return and deciding which one to utilize, as well as making other assumptions.
• There are online tools for estimating the cost of equity, however, computing the formula by hand or in Excel is an easy task.

Capital Asset Pricing Model Formula

Rate of Return Expected = Risk-Free Premium + Beta * (Market Risk Premium)

R_i = Expected return on the asset

R_f = Risk-free rate of return (usually the yield on government bonds)

β = Beta of the asset (measure of its volatility compared to the market)

R_m = Expected return on the market portfolio

Example of CAPM

Let’s imagine you want to invest some of the funds you have in equities that are now priced at ₹153 but offer 6% annual returns. If we assume that this particular firm has a beta factor of one, we can calculate the expected dividend earnings by factoring in the risk-free premium of 2.5 percent and the investor’s estimate of an annual market gain of 8%. After inputting all of the required facts into the equation, one could come to the following conclusion,

R_i = 11.5%

How can CAPM be Used?

1. Expected Returns: The CAPM method is used to calculate an asset’s expected return. It is based on the idea that buyers should be rewarded extra for systematic risk, which is also called non-diversifiable risk. This extra money is called a risk premium. Sometimes the rate of return is better than the risk-free rate. This is called a risk premium. Researchers have found that when investors make riskier bets, they want a higher risk premium.

2. Cost of Equity: The cost of equity for a company can be seen with CAPM. The cost of equity is a part of the weighted average cost of capital (WACC), which is used to look at investment possibilities through discounted cash flow (DCF) analysis.

3. Portfolio Making: By looking at the trade-off between risk and profit, CAPM can help investors build portfolios that work well. Investors may expand their portfolios to get the amount of risk they want while also getting the best expected returns by choosing assets with different betas.

4. Valuation: CAPM can be used to figure out how much a product or company is worth. Analysts can figure out what an asset or a company’s stock is really worth by using CAPM to guess the required rate of return.

5. Evaluating Performance: CAPM gives us a standard to measure how well financial managers are doing. When managers regularly do better than the expected returns based on the CAPM model, this is called “generating excess returns,” and it shows that they are good at choosing assets or timing the market.

6. Risk Management: CAPM can help you figure out how to measure and handle systematic risk in your trading portfolios. Investors can protect themselves from market risk and lower the volatility of their portfolios by knowing the systematic risk of each asset.

7. Making Strategic Choices: When it comes to company finance, CAPM can help with strategic decisions like capital budgeting and project evaluation. Firms can make better decisions about how to use their resources by using the cost of equity from CAPM to help them make business decisions.

How CAPM Work?

CAPM gives investors a way to figure out what the anticipated return on an investment will be. This way, they can compare the possible return of different assets. You can use this comparison to figure out if the projected return is worth the risk of the investment.

Why Capital Asset Pricing Model is Important?

1. Understanding the Relationship between Risk and Return: CAPM offers a structured approach for understanding the connection between investment risk and the expected return that investors seek in exchange for taking on that risk. It calculates the relationship by calculating the anticipated return on an asset based on its risk characteristics.

2. Cost of Capital: The cost of capital is calculated using CAPM, which is important for estimating the weighted average cost of capital (WACC). WACC is commonly employed by companies as a discount rate to evaluate investment projects. Ensuring the company uses a suitable hurdle rate for investment decisions involves precisely calculating the cost of equity through CAPM.

3. Managing Portfolio: Portfolio managers rely on CAPM to help them create well-balanced portfolios that consider both risk and return. It assists in making investment decisions by discovering assets that provide the most favorable risk-adjusted returns. Through careful selection of investments across various assets, investors can enhance the performance of their portfolio.

4. Asset Valuation: CAPM offers a method to evaluate the value of particular assets or entire companies. Through the process of discounting future cash flows at the asset’s required rate of return estimated by CAPM, analysts are able to calculate their present value. This valuation approach is commonly employed in the field of finance to price securities and establish fair market value.

5. Evaluating Performance: CAPM is commonly used to assess the success or failure of investment managers. Through a comparison of the actual returns generated by a portfolio with the returns predicted by CAPM, buyers can evaluate whether the manager has successfully added value through active management or has merely mirrored the market.

6. Capital Budgeting: In capital budgeting decisions, in which firms evaluate whether to invest in long-term projects, the CAPM model helps estimate the appropriate discount rate. Projects with a higher level of systematic risk should be discounted at a higher rate to account for the increased risk they bring to the company’s overall portfolio.

7. Policy Making: Insights from CAPM are important for policymakers in fields like finance regulation, assessments, and monetary policy. Having a deep understanding of the connection between risk and return enables policymakers to develop regulations and policies that foster market efficiency and stability.

In general, CAPM holds significance as it offers a theoretical framework and practical tools to comprehend risk and return in financial markets. It helps in making informed investment decisions, valuing assets, managing portfolios, evaluating performance, and shaping policies.

Problems with CAPM

Although the Capital Asset Pricing Model (CAPM) is commonly used and has had a significant impact in the field of finance, it is not free from its fair share of limitations and criticisms. There are several significant issues associated with CAPM:

1. Assumptions: The CAPM model is based on a number of simplifying assumptions that could fail to accurately represent the complexities of real-world markets. For example, it assumes that investors have similar expectations, that markets are extremely competitive and efficient, and that there are no taxes or transaction fees. These assumptions can result in false conclusions and may fail to accurately capture the complexities of the market.

2. Single-Factor Model: The CAPM is a single-factor model that solely takes into account the systematic risk (beta) when determining asset returns. It disregards other sources of risk, such as business-specific variables, risk of liquidity, and political risk, and assumes that the only significant risk is the one that cannot be diversified away. This oversimplified perspective may fail to fully grasp the wide range of risks that investors encounter.

3. Market Substitute: Typically, CAPM uses a broad market index, such as the S&P 500, as a substitute for the market portfolio. However, it’s important to note that this might not accurately represent the portfolios of all investors, particularly those who have different investment goals or limitations. Using an inadequate proxy for the stock market portfolio may result in incorrect projections for anticipated returns and cost of equity.

4. Estimation of Betas: Estimating betas for individual assets can be quite challenging, especially for assets with limited past information or those that serve unique industries or regions. Even slight adjustments to beta estimates can have a significant impact on the calculated cost of equity, potentially resulting in mispricing of assets.

5. Empirical Evidence: Various studies have produced conflicting results regarding the accuracy of CAPM’s forecasts. Although the CAPM model proposes a direct correlation between anticipated returns and beta, various empirical studies have revealed that this relationship can be uncertain or inconsistent, particularly when examining extended timeframes or diverse market conditions.

6. Different Models: There are alternative asset pricing models available, such as the Fama-French Three-Factor Model and the Arbitrage Pricing Theory (APT), that provide greater flexibility and potentially stronger explanatory power compared to CAPM. These models consider additional factors beyond beta, offering a more comprehensive framework for asset pricing.

7. Market Anomalies: Traditional capital asset pricing models do not take into consideration the numerous market anomalies and behavioral biases that are commonly observed in financial markets. These include the size effect, value effect, and momentum effect. These irregularities indicate that specific asset classes consistently exceed or fall short of CAPM’s projections, which challenges the model’s efficiency as a pricing tool.

Capital Asset Pricing Model (CAPM) – FAQs

What does the Capital Asset Pricing Model (CAPM) stand for?

CAPM is an equation that shows how anticipated return and risk are related for different types of stocks. It helps buyers figure out how much money they can expect to make from an investment based on how risky it is.

How does CAPM work?

It figures out an asset’s expected return by adding the risk-free rate to a risk premium. The risk premium is equal to the asset’s beta (systematic risk) times the market risk premium, which is the difference between the expected return on the market portfolio and the risk-free rate.

What are the main ideas behind CAPM?

For CAPM to work, it assumes that investors are logical, similar, and afraid of taking risks. It also assumes that markets are efficient, there are no taxes or transaction costs, and all investors have access to exactly the same information. These factors make the model easier to understand, but they might not fully reflect how markets work in the real world.

What does beta mean in CAPM?

Beta shows how sensitive an asset’s returns are to changes in the returns of the whole market. A beta of 1 means that the asset moves in the same way as the market. A beta greater than 1 means that the asset is more volatile than the market, while a beta less than 1 means that it is less volatile than the market.

How is CAPM used in real life?

CAPM is used for many things, such as calculating the expected return on investments, estimating the cost of equity for businesses, building efficient portfolios, judging the success of investments, and valuing assets.

What are the problems with CAPM?

There are a few problems with CAPM, such as the fact that it relies on simplifying assumptions like the single-factor model and the idea that markets work well. It’s also hard to get exact estimates of betas, and real-world evidence goes against what it says.