Capital asset pricing model or CAPM formula is commonly utilized while investing. It is crucial in determining the weighted average cost of capital (WACC), as CAPM computes the cost of equity. WACC is used extensively in financial modelling. It can be used to find the net present value (NPV) of the future cash flows of an investment and to further calculate its enterprise value and lastly its equity value.

 What is CAPM's goal?

To understand the CAPM model and its assumptions, we must grasp that this theory (and others) assume investors perceive price/valuation in relation to alternative investment options, which makes CAPM a helpful tool.

CAPM – a tool for valuing Equity

Let's understand the CAPM as part of a DCF model.

The CAPM helps investors estimate capital costs based on cash flows. What's the opportunity cost of an asset vs another? The CAPM as it has evolved today uses prior stock prices to compute "beta," which is applied to the cost of equity in a DCF valuation. Cost of equity is a key component of WACC. (Weighted Average Cost of Capital)

Let's test the CAPM to see why it's annotated in today's textbooks.

CAPM - Underlying Assumptions

A few market, investor, and other assumptions must be true for this model to accurately measure risk appetite and how much (or little) to discount cash flows to determine a security's price.

• Beta's systemic security risk
• Returns are bell-shaped.
• Market expectations are stable.
• Markets are efficient and consider all data.
• Reasonable investors and stable markets.
• Loans are risk-free and unrestricted.
• Trading the asset is free and liquid.

Let's build on these assumptions because some are more likely than others. Some CAPM assumptions have inherent benefits and drawbacks.

Systemic risk and normally distributed returns

Many disputes and contest these two assumptions of the CAPM model.

Research on stock market risk has shown that tail risk cannot always be described by a bell curve. A normally distributed risk estimate may be meaningless if the difference between a bell curve and a "tail" is huge.

Taleb says:

"Assume ten people, nine with $30,000 and one with $1,000. 9 out of 10 people have a net worth of $27,100." Stock markets rarely face tail risk, or four, five, or six sigma events like the Great Depression, Black Monday, or Corona (of 2020). So, most of the time, tail risk and return distributions are non-issues, and not factoring them into the CAPM model is generally harmless.

Practitioners should be aware that tail risk can invalidate risk estimation, whether or not it harms them.

Beta as Risk Indicator

If taken at face value, the CAPM premise that beta is a good indication of systemic risk might make the model worthless. A CAPM practitioner can avoid this. Especially if the practitioner is satisfied additional sources of risk have been evaluated and a beta is adjusted if its value misrepresents the true inherent danger.

Assume a stock's beta is 0.01 Whatever Expected Market Returns and Market Risk Premium you choose, a beta close to zero will return a value near zero for [beta * Market Risk Premium].50% of the Cost of Equity formula is [beta * Market Risk Premium] (represented by the CAPM). 50% is risk-free rate. If beta x market risk premium is close to 0, your investment is risk-free. Now, that is unlikely unless you invest in a "risk-free" government bond.

Not just government bonds have low betas.

Many stocks have bankruptcy (complete capital loss) and other non-systemic risk.

One was that the stock price would crash, which it does when market volatility increases, and the other was that the stock would go bankrupt, which is always a hazard for a publicly traded corporation.

Using the CAPM with context and understanding is key.

The Efficient Market Hypothesis

Some of the world's best minds—Warren Buffett, Charlie Munger, Prof. Aswath Damodaran, etc.—have defined the efficient market theory far more brilliantly than I. To what extent the market is efficient can be a contentious issue because most people agree that it is efficient sometimes, if not often. Whether this indicates markets are so efficient that active stock management is a waste of time and harmful or that the CAPM accurately depicts asset values, is up for debate. This assumption must be validated using what we know about the CAPM to use it as intended.

Other assumptions, such as rational investors and equilibrium markets, can be factored into this core efficient market assumption. As practicality and theory are hard to differentiate in this context, their precise meaning is unclear.

In other words, market efficiency, investor rationality, and market equilibrium mean different things to academics and practitioners.

Be careful while making judgments based on market assumptions!

Fees, Liquidity

Liquid, fee-free markets can uncover pricing inefficiencies and remedy them quickly. Fees lower the effectiveness of arbitrage trades that close the pricing efficiencies gap, and the more fees, the less reliable the CAPM is as an asset price estimate. Non-liquid markets carry assets at inefficient prices (relative to their real value) until self-correcting market forces reduce the gap.

Real estate is less liquid and has higher transaction costs than the stock market, hence CAPM isn't typically used there.

Investors have limitations in being able to get unlimited amounts at the risk-free rate to adjust for pricing inefficiencies related to interest rates and discount rates.

So, is CAPM useful?

After this CAPM model deconstruction, you'd think I'd reject it as an intellectual aberration.

You must discount cash flows to assess if investing for future cash flows is worth more than cash on hand. There aren't many better ways to evaluate WACC's cost of equity than CAPM. Many of the CAPM's assumptions are not precise. But in practice, many such real-world assumptions are true or beneficial to varying degrees.

If used appropriately, CAPM is a superb stock-valuation technique. By admitting CAPM's limitations, investors can see the model's contribution to asset valuation efficacy.

Knowing CAPM's boundaries and strengths and drawbacks helps in its appropriate utilization.

After all we don’t lead perfect lives in a perfect world!

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