What is the Capital Asset Pricing Model (CAPM)?
The capital asset pricing model (CAPM) is a mathematical formula that attempts to establish a relationship between the systematic risk and expected return of an asset, mostly equities.
Systematic risk is the risk that investors cannot diversify away from, such as wars and recessions. Equity investors take on systematic risk and will therefore demand a higher return. This is the premise that CAPM builds upon.
The CAPM formula
The CAPM formula comprises two components: risk-free rate and risk premium.
In order to use the CAPM formula, you will need to understand some key concepts, as outlined below.
- Risk-free rate - This rate compensates an investor for the time value of money. For example, an investor can invest in a 10-year Treasury note and earn this rate of return without taking on any risk. The 10-year Treasury yield is the benchmark risk-free rate, but some investors may prefer to use shorter maturity bonds to match their investment horizon.
- Beta - A multiplier that accounts for the market’s systematic risk. When the expected rate of return is plotted on a graph, the slope of the line equals the beta. If an asset is riskier than the overall market, it will have a beta greater than one, and vice versa. Beta can also be negative when an asset is negatively correlated to the market. To summarize, beta adjusts the risk premium for the asset’s relative volatility with the market.
- Market risk premium - The beta is multiplied by the market’s risk premium (Rm – Rf), which is just the expected rate of return from the market reduced by the risk-free rate. This is the degree to which a certain asset class is riskier than the Treasury notes.
- Expected rate of return - The number added to the risk-free rate (i.e., beta multiplied with the market risk premium) is the rate that factors in the higher or lower risk associated with a specific asset. Adding these two numbers gives us an investor’s expected rate of return, also referred to as the discount rate.
Example of using CAPM to compute expected return
Let’s use the CAPM to compute the expected return for a US-based stock using the following information:
- 10-Year Treasury yield: 1.5%
- Average annual return for US equities: 10%
- Beta for our chosen stock: 1.5 (i.e., the stock is 150% more volatile or risky than the overall US equities market)
Based on the CAPM, the expected rate of return is 14.25%.
When is CAPM used?
The capital asset pricing model is a popular tool for several areas of finance, including equity research and corporate finance. Companies need information regarding their weighted average cost of capital (WACC) for making key financial decisions. For WACC, one of the inputs required is the cost of equity, which is computed using the CAPM.
Equity research analysts also use the CAPM for computing the cost of equity. They use the cost of equity in financial models for the calculation of the company’s future cash flow’s net present value (NPV). This helps them value a company and make stock recommendations to their clients.
Does CAPM help investors?
CAPM has been criticized by many industry professionals, primarily because of the beta. It’s worth noting that professors Eugene Fama and Kenneth French studied stock returns for all stocks listed on the New York Stock Exchange (NYSE), Nasdaq, and American Stock Exchange. Their research found that stock performance over a long period remains significantly unexplained by the differences in betas.
Nevertheless, CAPM continues to be widely used by industry professionals, investors, and fund managers. Even though there is disagreement on the viability of its use, the betas still offer investors and fund managers ample utility.
For instance, prices for high beta stocks tend to fall more when the market crashes. Investors and fund managers may decide to park their money in low-beta stocks instead of just holding low-yield liquid assets.
Research backs up the viability of the capital asset pricing model and addresses some of the concerns raised by its critics. That said, it has become increasingly common for professionals to question the CAPM. Unless there is a more effective model to replace it, however, the CAPM will continue to hold a critical spot in the toolkits of financial professionals and investors alike.