Capital Asset Pricing Model (CAPM)
CAPM is a mathematical model that describes the relationship between systematic risk and expected return for assets, particularly stocks.
Key Concepts
The capital asset pricing model prices the return an investor should demand for holding an asset: the risk free rate plus beta times the equity risk premium. It is the standard route to a cost of equity, and most of the argument in practice is about which inputs you use.
- Risk-Free Rate: The return of an investment with zero risk, usually govt bond yields.
- Beta (β): Measure of an investment's sensitivity to market volatility and movements.
- Market Risk Premium: The extra return expected from the market over the risk-free rate.
- Systematic Risk: Market-wide risks like inflation that cannot be diversified away.
- Unsystematic Risk: Company-specific risks that can be eliminated through diversification.
- Security Market Line: Graphical representation of CAPM showing return vs. Beta.
The Core CAPM Formula
The CAPM formula states that expected return is equal to the risk-free rate plus the Beta times the market risk premium.
This suggests investors must be compensated for the time value of money (risk-free rate) and for taking on systematic market risk (premium adjusted by Beta).
Understanding Beta
Beta is the most critical variable. A stock with a Beta of 1.2 is 20% more volatile than the market, requiring a higher return to justify the risk.
Conversely, a Beta of 0.5 suggests lower risk and lower expected returns. Analysts use Beta to gauge how an asset impacts a portfolio's risk profile.
Applications in Finance
For companies, CAPM is the primary method for calculating the "Cost of Equity," which is a key input for WACC and project valuations.
If a company's projects don't return at least what CAPM predicts for its risk level, it is effectively destroying shareholder value in the long run.
Real-World Critique
While theoretically sound, CAPM has limitations. It assumes market efficiency and that Beta is a perfect measure of risk based on historical data.
In reality, historical Beta may not predict future volatility perfectly, leading some analysts to supplement it with multi-factor models.
Foundational Theory
Despite its simplifications, CAPM remains the foundation of modern portfolio theory, offering a logical framework for risk-reward trade-offs.
Understanding CAPM is essential for justifying investment choices and setting realistic performance benchmarks in a competitive market.