CAPM stands for capital asset pricing model. It is referring to the methodology used to come up with a rate of return you should expect from a project or business (usually used for specific projects) when taking into account general market data or industry-specific data that the project or business is a part of.
The Capital Asset Pricing Model (CAPM) is a financial model that quantifies the relationship between the expected return on an investment and its systematic risk. It provides a framework for estimating the required return or cost of equity (used in WACC calculation) for an investment based on its risk characteristics.
The CAPM equation is as follows:
Expected Return = Risk-Free Rate + (beta × (Market Return − Risk-Free Rate))
Where:
Where:
- The risk-free rate represents the return on a risk-free investment, typically approximated by the yield of a government bond.
- Beta measures the sensitivity of the investment's returns to the overall market returns. It quantifies the investment's systematic risk relative to the broader market. A beta of 1 indicates that the investment's returns move in line with the market, while a beta greater than 1 indicates higher volatility, and a beta less than 1 indicates lower volatility.
- The market return is the expected return on the overall market portfolio (or specific industry the asset being priced is in).
Ideal Uses of CAPM:
Expected Return = 5% + (1.2×(10%−5%)) = 11%
In this example, the CAPM calculation estimates that the expected return on the stock should be 10%.
It's important to note that CAPM has certain assumptions and limitations, such as the efficient market hypothesis and the single-factor beta model. Therefore, it is often used in conjunction with other models and considerations for a more comprehensive analysis of risk and return.
- Cost of Equity: The primary use of CAPM is to estimate the cost of equity capital, which is the expected return required by investors for holding equity shares of a company. It is commonly used in valuation models, such as discounted cash flow (DCF) analysis, to determine the appropriate discount rate for valuing a company or its projects.
- Capital Budgeting: CAPM is used to determine the required rate of return for evaluating investment opportunities. Companies can compare the expected return of a project or investment to its cost of capital derived from CAPM to assess its feasibility and profitability.
- Performance Evaluation: CAPM can be used to evaluate the performance of investment portfolios or individual assets. By comparing the actual returns of an investment to its expected returns based on CAPM, investors can assess whether the investment has outperformed or underperformed relative to its risk level.
Expected Return = 5% + (1.2×(10%−5%)) = 11%
In this example, the CAPM calculation estimates that the expected return on the stock should be 10%.
It's important to note that CAPM has certain assumptions and limitations, such as the efficient market hypothesis and the single-factor beta model. Therefore, it is often used in conjunction with other models and considerations for a more comprehensive analysis of risk and return.
Article found in Valuation.
