Now that we’ve discussed beta and the Dividend Discount Model (DDM), I’d like to introduce you to one of my favorite equations, the CAPM (that’s pronounced cap-m, and it’s an acronym for “Capital Asset Pricing Model”). Right now, you’re probably asking yourself, “What sort of a person has a favorite equation?” As much as I hate to admit it, when I’m studying for the CFA exam and I come across the equation’s individual components in a practice question (Risk-free rate? Check. Beta? Check. Market risk premium? Check), I can hardly contain my excitement.
OK, so I’m slightly prone to hyperbole. But it is a very useful tool for asset valuation, and one of its merits is its simplicity. The equation is basically that of a simple linear regression, which you might remember as the equation of a line (y = mx + b). Here, “b” is the risk-free rate (the rate of return on a risk-free asset, like a Treasury bill), “m” is beta, which is a measurement of an asset’s systematic risk (see my earlier blog on beta for a more thorough explanation), and “x” is the market risk premium, or the difference between the market return and the risk-free rate of return. Plug in the variables, do a little calculation, and the result is an asset’s required rate of return, r.
So what does this tell you? Probably that you have long since forgotten the equation of a straight line. But other than that, you might notice that the CAPM required rate of return is dependent on the equation’s inputs. For example, holding everything else constant, a higher beta will result in a higher required rate of return. That makes sense, because a higher beta indicates a higher level of systematic risk, and you would expect to be compensated for taking on more risk by the possibility of earning a higher return. We can even go a step further and tie in to the DDM, because r (the required rate of return, which can be calculated via the CAPM) is part of the DDM equation. The DDM tells us that, all else equal, a higher r will result in a lower intrinsic value. If the stock price is higher than its intrinsic value, you may deem that stock to be overvalued.
Of course, a model can’t be this gorgeous without making a LOT of simplifying assumptions. For example, the CAPM assumes that all investors have identical expectations, and that there are no taxes or transaction costs (what a wonderful world it would be, right?). Nevertheless, the CAPM has played an integral part in the development of modern portfolio theory since its introduction in the early 1960s. Plus, I just HAD to tell someone about my favorite equation. Of course, now that summer is here, I can put aside the study books and turn my attention to other matters of great importance. Now, where did I put that issue of Us Weekly?
Research and Trading Associate