Harry Markowitz first proposed the CAPM formula as part of modern portfolio theory to calculate an expected return for any security. For those that provide optimal risk-reward ratios, an efficient frontier exists which provides guidance as to where best opportunities lie.
This article will introduce the basic components and limitations of the model, as well as demonstrate how it can be utilized to calculate project-specific discount rates.
What is CAPM?
CAPM (Capital Asset Pricing Model) is an essential concept in finance that provides a standardized method to assess expected returns based on an investment’s risk profile. Investors, financial analysts, and businesses use CAPM as a way of estimating fair values of assets or companies.
Calculating an investment’s expected return using CAPM requires using two formulae. Rm = (Risk-Free Rate) + (Beta * Market Risk Premium). The risk-free rate refers to what would be earned on investments that carry no risk, such as government bonds; market risk premium represents what should be expected as additional returns as compensation for risk in any investment decision made.
Investors tend to be rational and risk-averse; when making investment decisions they weigh the benefits against its risks. Therefore, when searching for investments they seek those offering higher expected returns than market risk premium; CAPM makes several assumptions which may or may not hold true in practice.
How does CAPM work?
CAPM seeks to link an investment’s required return with its systematic risk. It operates under the assumption that investors require greater returns when investing in riskier assets.
The model emphasizes systematic risks that affect all investments equally and are unavoidable, such as inflation, interest rates and government monetary policy. It does not take into account unsystematic risks unique to individual investments such as industry regulations, capital structures or competition risks that might pose threats.
The CAPM model also assumes that the market risk premium, or additional return beyond risk-free rates that is available for taking on stock market risks, remains constant over time. Estimating historical data can provide insight into this figure and securities are evaluated against it using graphs that compare expected returns against risk (beta). If they lie above or below an efficient frontier respectively they could be under or overvalued, respectively. Using financial software analysts can estimate inputs and calculate expected returns using CAPM formula.
Why is CAPM used?
Financial advisors commonly utilize CAPM as an effective way of helping their clients understand the fair value of shares and other investments. It is especially helpful when market conditions lead to investors to reevaluate prices and returns; for example, as interest rates rise, stock returns could potentially rise as well, prompting clients to recalculate risk/reward ratios to determine if continuing purchase would still make financial sense at its current price point.
CAPM examines incremental systematic risk beyond “risk-free” levels and is founded in economic principles such as opportunity cost. An investor looking to accumulate wealth would obviate any investment with returns below those mandated by CAPM.
While CAPM remains essential, there are several criticisms and limitations. For instance, the model assumes all investors are rational and risk averse – which may not always be accurate in practice – while also making assumptions about beta and market participants that may not reflect reality.
What are the assumptions of CAPM?
CAPM’s foundational assumptions focus on the nature of capital markets. These include perfect efficiency, which holds that all relevant information reflected in asset prices; all investors act rationally in seeking to maximise utility; and all securities can be bought and sold at equal prices without incurring transaction costs, taxes or inflationary inflationary cost.
Key assumptions include that market returns (rm) equal the risk-free rate (rf), while security beta remains constant over time. Unfortunately, in practice this does not always correspond with actual market conditions and can often fluctuate due to fear and greed-induced fluctuations. Furthermore, in real transactions stocks and bonds often require minimum purchase amounts that cannot be divided by fractions – therefore negating this assumption that securities could be divided infinitely.
CAPM relies on one single risk factor (beta) to explain asset returns, which may oversimplify real-world complexity. Thus, multifactor models have emerged to address its flaws.
