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Capital asset pricing model

How can capital asset pricing model support strategic choice or positioning?

AccessibleStrategicOrganisation2 min read

Contents

The capital asset pricing model (or CAPM, as it is universally known) estimates the expected return for a firm’s stock.

The capital asset pricing model (CAPM) estimates the return investors should require from a security given its exposure to market risk. It combines a risk-free return with a premium derived from the expected market return and the security’s beta.

When to use it

To estimate the required return or discount rate for a security, such as a company’s shares.

To examine the trade-off between systematic risk and expected return.

To estimate a cost of equity for valuation and capital-investment analysis.

Origins

CAPM was developed independently during the 1960s by William F. Sharpe, John Lintner and Jan Mossin, with related earlier work by Jack Treynor. Sharpe’s route began in 1960 when he approached Harry Markowitz for a doctoral topic and extended Modern portfolio theory (Finance); thumbnail basis: modern-portfolio-theory-figure-01.jpg. from portfolio selection to equilibrium asset prices. His nineteen sixty-four article “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk” became the best-known formulation. In 1990 Sharpe shared the Nobel Memorial Prize in Economic Sciences with Markowitz and Merton Miller for pioneering contributions to financial economics.

What it is

CAPM separates return into compensation for time and compensation for systematic risk. The risk-free rate, Rf, represents the return available without taking market risk, often approximated using a government-security yield with a maturity and currency appropriate to the cash flows. The market risk premium, Rm − Rf, is the additional return expected from the market portfolio.

Beta, βa, measures how sensitively an asset’s returns move with the market. The market beta is 1.0. A diversified large-company share may have a beta near 1.0; a technology stock whose returns amplify market movements may exceed 1.0; a defensive utility may have a beta below 1.0. Beta describes market-related risk, not every source of uncertainty in the company.

Sharpe’s relationship is:

ra = rf + βa (rm − rf)

where Ra is the asset’s required return, Rf the risk-free rate, βa the asset beta and Rm the expected market return. In words, required return equals the risk-free rate plus beta multiplied by the market’s excess return.

Suppose the risk-free rate is 3.0 per cent, the stock beta is 2.0 and the expected market return is 6.0 per cent. CAPM gives 3 per cent + 2.0 × (6 per cent − 3 per cent) = 9.0 per cent. For securities assessed in the same market and period, the risk-free rate and market premium are common inputs; beta drives the difference in required return.

How to use it

Choose inputs consistently. Use a risk-free rate in the same currency and with a duration suited to the asset or cash flows. A 10-year US government yield may be a practical proxy for a long-lived US-dollar valuation, but it is not universal.

Estimating the expected market return is harder because realised returns vary widely. A historical range of roughly 5–7 per cent is sometimes used as a starting point in this example; if the risk-free yield were 2.6 per cent, that would imply a market premium between 2.4 and 4.4 per cent. In professional valuation, state whether the premium is historical, survey-based or forward-looking and test sensitivity.

Published betas are available from financial-data services such as Bloomberg. To estimate beta directly, collect two or five years of weekly or monthly returns for the security and a representative market index—often the S&P 500 for a US share—and regress the security’s excess return on the market’s excess return. Check the observation period, frequency, index and any leverage adjustment, because each choice can change the result.

Top practical tip

Use CAPM as a transparent baseline and test the inputs. Historical beta may not describe a changed business: GE’s predictable 1990s earnings and more volatile early-2000s performance illustrate how a backward-looking estimate can become misleading after the company’s risk changes.

Top pitfall

Do not mistake CAPM’s precision for certainty. Empirical support is mixed: Fama and French’s study of US returns from 1963 to 1990 found that company size and book-to-market characteristics helped explain returns beyond beta, and the beta–return relationship may be weak over short periods.