Capital Asset Pricing Model (CAPM) is one of the models used to estimate the cost of equity. CAPM, developed by William Sharpe, the Nobel Laureate in Economics, defines a stock’s risk as its sensitivity to its market. In other words, when we invest funds, we expect a rate of return against the risk taken. CAPM helps us derive the investment risk and the return we can expect on our allocated fund. As an analyst, CAPM should be used to decide the price the investor should pay for a particular stock. If Stock A is riskier than Stock B, Stock A should be priced lower to compensate investors for the increased risk.
CAPM defined by the following formula, says that the expected rate of return on any security equals the sum of risk-free rate and the security’s Beta times the market premium risk
E(Rs) = Rf + Bs * [ E(Rm) – Rf ]
Where,
E(Rs) = Expected return of the security, s
Rf = Risk-free rate
Bs = Stock’s sensitivity (how the stock and the market move together)
E(Rm) = Expected return of the market
In CAPM, the Rf and the market risk premium, E(Rm) – Rf), remains common to all companies, but it is the Beta, Bs, that varies – Bs is the stock’s incremental risk. While it’s not absolutely clear, the CAPM says that the only reason an investor should gain more from Stock A compared to the Stock B is the increased risk taken on Stock A.
Few points noteworthy:
- To estimate the risk-free rate, we use highly liquid long-term government bonds like 10-year zero coupon STRIPS, US Treasury bills, etc. as a proxy.
- Beta: If a stock price exactly replicates the market, its Beta is 1. A stock with a beta of 1.2 means it’s theoretically 20% more volatile than the market.
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