The Capital Asset Pricing Model (CAPM) helps us understand the relationship between the risk and expected return for stocks. CAPM calculator is used to calculating the Cost of Equity.
Capital Asset Pricing Model, CAPM
The capital Asset Pricing Model ( CAPM) is a mathematical model that describes the linear relationship between risk and returns for securities. It gives investors an understanding of the risk-return trade-off for investments.
In other words, CAPM model provides a formula to calculate the expected return on security based on the level of risk attached to the security. Cost of Equity or Require rate of return is a more formal name for Discount Rate.
The risks to which security is exposed can be classified into two groups:
- Unsystematic Risks: This is also called company-specific risk as the risk is related to the company’s performance. This type of risk can be eliminated by having diversification in an investment portfolio. It is also known as a diversifiable risk.
- Systematic Risks: It is the market-specific risk under which a company operates. This type of risk cannot be eliminated by the diversification of an investment portfolio. For example Government monetary policy, Inflation etc.
The CAPM method provides the formula to calculate the non-diversifiable / systemic risks associated with an investment. The non-diversifiable risks are assessed in terms of beta coefficient (β) through fitting regression equation between the return of a security and return on a market portfolio.
It is a technique used to find out the required rate of return for a particular project/ investment. The required rate of return is also known as the discount rate and/or the cost of equity. In investment, the rate of return is dependent on the risk involved in any project.
The higher the risk of a project, the investors need to be compensated for that higher risk. If you want to invest in a risky project, the investment should have a higher rate of return compared to a safe and stable investment. This higher required rate is the risk premium.
In simple words, the risk premium is the difference between the rate of return offered in the market and the risk-free rate of return.
Below is the CAPM formula
- The idea behind the CAPM model is that Investors need to be compensated for two things – Time Value of Money and the associated Systemic Risk of the investment.
- The time value of money is represented by the risk-free rate in the formula and compensates an Investor for placing money in any Investments over a period of time. Time Value of Money is can be explained with Net Present Value (NPV) concept.
- The second half of the formula talks about Risk and calculates the amount of compensation the investor needs for taking on additional risk. Here, Beta(β) is the volatility of the stock. You can find beta for each stock at morningstar.com
- Risk-Free Rate is the interest/return an investor should get for zero-risk investments. The government’s long term (i.e. 10Y) treasury bond yield is considered as lowest risk. USA Risk-free rate at FRED Website
- Market’s Annual Return is the average annualised historical return of the stock market. Long term (20-30Y) USA stock market returns around 10%, US Historical Market Return
CAPM model says that the return of security must be equal to the rate on risk-free security plus a risk premium. If the expected return of an Investor does not meet or exceed the required return, then the investment should not be undertaken.
Advantages of CAPM
- CAPM is a simple formula that can be easily calculated and stress tested.
- It establishes the theoretical relationship between risk and return.
- It considers the systematic risk
Limitations of CAPM Model
- Estimating beta with historic values is unrealistic.
- Market imperfections may lead investors to unsystematic risk
- The assumption of risk-free rate is unrealistic.