Home Training An explanation of the capital asset pricing model (CAPM).

An explanation of the capital asset pricing model (CAPM).

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What is CAPM (Capital Asset Pricing Model)?

The Capital Asset Pricing Model (CAPM) is a model used to calculate a company’s cost of equity capital based on its risk as represented by the beta of its stock. From an investor’s perspective, the CAPM is used to calculate the expected return on a stock investment. According to this theory, the only way an investor can earn above-average returns is to invest in riskier securities.

In short, the CAPM is a model used in the financial sector to describe the relationship between the expected risks and returns of an investment. While many investors question the CAPM model, it is still widely used in the financial sector.

Explanation of the CAPM formula

According to the capital asset pricing model (CAPM), the company cost of equity is equal to:

Cost of equity = Rrf + [β x (Re – Rrf)]

Where:

  • Rrf = risk free rate
  • β = Beta stock
  • Re = expected return on the stock market
  • (Re – Rrf) = equity risk premium

Let’s break down each component of the formula:

  • Risk free bet: The risk-free rate is equal to the yield on 10-year government bonds of the country where the company operates. For example, if we want to calculate Netflix’s cost of equity, we have to take the yield on 10-year US Treasuries as the risk-free rate.
  • beta (b): The beta is a financial indicator that measures the volatility of share price changes compared to the market. According to SARM above beta equals higher risks. However, many investors disagree with this approach to risk assessment because investment risk should be assessed based on a company’s fundamentals, not changes in its stock price.
  • Equity risk premium: The equity risk premium represents the excess return of the stock market over a 10-year government bond. Market yields and Treasury rates can fluctuate significantly from time to time, resulting in different equity risk premiums. Therefore, investors calculate the equity risk premium using the methodology they deem most appropriate. Here at Finbox, we calculate the equity risk premium using Duff & Phelps methodology.

CAPM formula infographic

An example of a CAPM calculation is Netflix’s cost of equity

To illustrate, we can calculate Netflix (NASDAQGS: NFLX) cost of equity capital using the CAPM formula. Z Finbox data explorerwe can find the values ​​of the indicators needed to apply the formula:

Here is the calculation of Netflix’s cost of equity (expected return) using the CAPM formula:

Cost of Equity = Risk Free Rate + Beta*Equity Premium

Cost of equity/expected return = 0.70% + 0.97*5.5% = 6.03%

CAPM Calculator is a free Excel template

You can calculate the CAPM and WACC for every company in the world that uses it template. You just need to enter the necessary data of the company whose ratio you want to calculate, and the model will do everything automatically.

You can use Finbox data explorer to get all the data you need for more than 100,000 companies worldwide.

Here’s a preview of Finbox’s CAPM calculator:

capm wacc calculator template

Disadvantages of CAPM

Although the capital asset pricing model is widely used in financial modeling to estimate the equity value of a business, it has some serious drawbacks. Like most theoretical models, the CAPM does not actually reflect reality. So, let’s discuss some of its disadvantages:

1# βeta is not an objective measure

As discussed above, the beta of a stock is equal to the volatility of price changes compared to the market. If we choose different periods, we will get different betas, which will lead to conflicting assessment of investment risk.

For example, here is Apple’s βeta over different periods:

  • βeta Apple (5-year) = 1.31
  • βeta Apple (2-year) = 1.02
  • βeta Apple (1 year) = 0.98

As you can see, two analysts using different βeta will get different results.

2# Volatility is not risk

One of the basic assumptions of the capital asset pricing model is that stock volatility represents investment risk. But this statistical approach often does not reflect reality. Let’s take a look Apple (NASDAQGS:AAPL)as an example of a stock.

Disadvantages of CAPM - Beta from Apple

Source: Finbox’s fundamental chart editor

As shown above, Apple is one of the few that has weathered the COVID-19 pandemic. Its stock price skyrocketed due to valuation figures, resulting in an extremely inflated stock price. More expensive stocks usually equal riskier investments, right?

However, Apple’s 1-year beta is significantly lower than the corresponding 5-year metric. Therefore, according to the capital asset pricing model, Apple stock is now less risky than in the past. Of course, Apple’s valuation tells a very different story.

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