CAPM Advantages and disadvantages
Capital Asset Pricing Model (CAPM)
1. WHAT IS CAPM MODEL
The capital asset pricing model (CAPM) is a financial model used to calculate the relationship between expected returns as well as the risk of investing in specific stocks or securities. The idea behind the CAPM is that investors demand an additional expected return (and also known as risk premium) when asked to accept additional risk above that found in a risk-free asset (for example, T-bills). The CAPM originated from the Nobel Prize-winning studies of Harry Markowitz, James Tobin, and William Sharpe.
2. UNDERSTANDING CAPM
The capital Asset Pricing Model or CAPM is based on the premise that equity investors need to be compensated for their assumption of systematic risk in the form of a risk premium, or (and) the amount of market return in excess of a stated risk-free rate. A proper assessment of the capital asset pricing model requires a clear understanding of both systematic and unsystematic risk.
Systematic risk is the risk related to the overall market, which is also known as non-diversifiable risk. A company’s level of systematic risk depends on the covariance of its share price with movements in the overall market, as measured by its beta (β).
Unsystematic or “specific” risk is the company- or/ and sector-specific and can be avoided through diversification. Hence, equity investors are not compensated for it (in the form of a premium). As a general rule, the smaller the company and the more specified its product offering, the higher its unsystematic risk.
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3. CAPM FORMULA
The CAPM formula is:
Ke = Rf + ß * (Rm – Rf)
- Ke = Expected return on financial asset
- Rf = the current return on risk-free assets
- Rm = the expected average return of the market
- (Rm – Rf) = the average risk premium above the risk-free rate that a “market” portfolio of assets is earning
- ß = the beta factor, is the measure of the systematic risk of a particular asset relative to the risk of a portfolio of all risky assets. Beta is a measure of the risk of the shares of a company. ß is the co-variance between the return on sample stock and the return on the market. In order to determine the appropriate beta factor for a company, consideration must be given either to the market beta of the company and/or the betas of comparable quoted companies.
4. Is the CAPM Useful?
The Capital Asset Pricing Model is an elegant theory with profound implications for asset pricing and investor behaviour. But how useful is the model given the idealized world that underlies its derivation? There are several ways to answer this question.
- First, we can examine whether real-world asset prices and investor portfolios conform to the predictions of the model, if not always in a strictly quantitative sense, and least in a strong qualitative sense.
- Second, even if the model does not describe our current world particularly well, it might predict future investor behaviour. For example, as a consequence of capital market frictions being lessened through financial innovation, improved regulation and increasing capital market integration.
- Third, the CAPM can serve as a benchmark for understanding the capital market phenomena that cause asset prices and investor behaviour to deviate from the prescriptions of the model.
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5. CAPM Advantages
a) Simple and Easy
The capital asset pricing model is a widely used, return model that is simple and easy to calculate. These calculations are reliable and allow investors to make informed decisions when choosing equities.
b) Useful for Calculating WACC
CAPM model is useful for calculating the cost of equity (CoE) under WACC and the same can also be used to value a business under the DFC model.
c) Systematic Risk
CAPM provides a framework for measuring the systematic risk of individual security and relates it to the systematic risk of a well-diversified portfolio. In the context of CAPM, the risk of an individual security is defined as the volatility of the securities return vis-à-vis the return of a market portfolio.
d) Investment Appraisal
An investor can also use CAPM for investment appraisal compared to other rates; it offers a superior discount rate. This model clearly links required return & systematic risk.
e) Estimation of future cash flows
In the Capital Asset Pricing Model (CAPM), a stock’s expected return does not depend on the growth rate of its expected future cash flows. To find the expected return of a company’s shares, it is thus not necessary to carry out an extensive financial analysis of the company and forecast its future cash flows. According to the CAPM, all we need to know about the specific company is the beta of its shares, a parameter that is usually much easier to estimate than the expected future cash flows of the firm.
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6. Disadvantages of the CAPM model
a) Frequent changes in Risk-free rate
The widely accepted securities as risk-free are subject to regular yield changes and it creates volatility under the CAPM model.
b) Too many assumptions
The results provided by the CAPM model may not be accurate always as the model is dependent on too many assumptions and some assumptions may go unrealistic.
c) Determination of Project Proxy Beta
Businesses that use the CAPM to assess an investment need to find a beta reflective of the project or investment, so often, a proxy beta is necessary. However, accurately determining one to properly assess the project is difficult and can affect the reliability of the outcome.
d) Assigning values to CAPM variables
To use the CAPM, values need to be assigned to the risk-free rate of return, the return on the market, or the equity risk premium (ERP), and the equity beta. The yield on short-term government debt, which is used as a substitute for the risk-free rate of return, is not fixed but changes regularly with changing economic circumstances. A short-term average value can be used to smooth out this volatility. Finding a value for the equity risk premium (ERP) is more difficult. The return on a stock market is the sum of the average capital gain and the average dividend yield.
e) Dependence on systematic risk
CAPM assumes that a security’s required rate of return is based only on one factor, i.e., systematic risk. However, other factors such as relative sensitivity to inflation, dividend payout and others may also impact a security’s return.
The Capital Asset Pricing Model is a fundamental contribution to our understanding of the determinants of asset prices. The CAPM tells us that ownership of assets by diversified investors lowers their expected returns and raises their prices. Moreover, investors who hold undiversified portfolios are likely to be taking risks for which they are not being rewarded.
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