The core goal of investing money is to generate value, whether in stocks or other financial assets such as bonds. In investing, two things are imperative: i) return on investment and ii) risk involved. One can not exist without the other; if you invest in the equity market, you are prone to market fluctuations daily, which creates a question on how much return you should get on the risk undertaken? You can find this answer using the Capital Asset Pricing Model or CAPM.
What is CAPM?
Capital Asset Pricing Model is the calculation to determine how much return can be expected given a certain percentage of risk. In corporate finance, the CAPM formula holds significance as it helps find the cost of equity investment which is necessary for calculating the Weighted Average Cost of Capital (WACC). WACC helps in finding the real risk-return trade-off for a diversified portfolio.
The model was invented by the prominent economist and Nobel laureate William Sharpe in the early 1960s, which he later published in his book named Portfolio Theory and Capital Markets in 1970. He is also the inventor of the famous ‘Sharpe Ratio’. Each portfolio has a different cost of capital and degree of risk. As a result, one size doesn’t fit all and demands an efficient pricing model to gauge how much risk should be taken to gain a certain return and if it’s even worth it at all! CAPM model is the solution here.
The CAPM model considers the systematic risk of investment. If you wonder what systematic risk is, recall the market volatility when interest rate changes occur? In simple words, anything that affects the stock market becomes a systematic risk. With the inclusion of this market risk, the cost of equity returns becomes much more realistic.
These terms may sound complicated, but with some basic understanding, you can ace the calculation of the CAPM model.
How to calculate CAPM?
The CAPM formula is essential to ensure that the return on equity is at least equal to the cost involved. If it is less, the investment is a red flag and vice versa.
CAPM formula:
Ra = (Rrf) + [βa * (Rm- Rrf) ]
Whereas,
- Ra = Expected return on equity asset
- Rrf = Risk-free rate of investment. Typically, the risk-free rate is equal to the 10-year US government bond. Though, the appropriate way is to consider country-specific bond rates.
- Ba = Beta (volatility) of the equity investment or stock. It shows the correlation of investment with the market fluctuations. For example, if a stock increases by 10% in reaction to market volatility, the Beta is said to be 1.1. The higher the Beta, the more the sensitivity to the market. If the Beta equals 1, the stock will behave the same as the market volatility; 1% move for 1% volatility. Beta can also be negative, which means that the stock value would reduce with regard to the market.
- Rm – Rrf = Expected return of the market – Risk-free rate (Known as Risk Premium)
Deduction of the risk-free rate of investment from the expected market return is also known as the market premium. The conscience here is that investors always prefer higher returns than the risk taken; they want a premium beyond the risk-free rate. The risk premium, in simple words, is investors’ compensation for undertaking the risk. We can also write the CAPM formula as:
Expected return on equity = Risk-free rate (Beta of investment – Market premium)
Let’s understand the CAPM model better with the example.
CAPM example:
The XYZ stock trades around Rs. 500 per share, and you expect to get a 5% return on this stock. It has a beta of 1.3, the market is likely to increase at the rate of 8%, and the risk-free rate is 3.5%. What is the cost of equity in this case or the return that can compensate you for the risk taken?
Ra = (Rrf) + [ βa * (Rm- Rrf) ]
Ra = 5 + [1.3 * (8 – 3.5)]
The return on your equity investment will be 10.85%.
Advantages of using CAPM
Below are the advantages of using CAPM.
- The CAPM model considers the market risk, the systematic risk for investment, making the calculation realistic.
- It helps calculate the cost of equity and, in turn, find the total cost of capital, aka WACC.
- Compared to other models for calculating equity cost, such as the Dividend Growth Model (DGM), the application of CAPM is easier and has greater scalability.
Shortfalls of CAPM model
Below are the disadvantages of using CAPM.
- CAPM is based on assumptions that there is perfect competition in the market and the market is highly efficient, which is not the case typically. There is always an opportunity to benefit from arbitrage trades.
- Another assumption on which CAPM is based suggests that the investors are rational and averse to the risk. That is also a highly unrealistic expectation since investors often trade with emotions and are not rational.
- The CAPM model doesn’t account for taxes an investor has to pay, which can sometimes reduce their returns. For example, In India, an investor has to pay a 10% long term capital gains tax on long term investment gains. This is not a part of calculating the cost of equity.
- Apart from this, the other drawbacks include challenges to calculate Beta and potential frequent changes in the risk-free rate.
The bottom line
Since its inception, the CAPM model has been used widely in the banking and finance industries. It helps in identifying assets worth investing in. It also played a vital role in bagging its inventor William Sharpe his joint Nobel prize. Yes, there are some assumptions used by this theory that has been a topic of debate for ages, but still, its application, without a doubt, holds significance.
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