The Capital Asset Pricing Model, or CAPM for short, is a popular pricing model used by investors to value risky assets. The CAPM is based on the principles of modern portfolio theory and can be used to determine whether a risky asset is measured at fair value. The CAPM can then be used as a discount rate or, for example, as a cost of equity when calculating your weighted average cost of capital (WACC) for a discounted cash flow valuation model.
CAPM calculates the expected return on an investment by adding the risk-free rate of return to the market risk premium multiplied by the beta of the investment.
ER = Rf + B (ERm-Rf)
The risk-free rate of return is a theoretical rate used to describe the return on a risk-free investment and it represents the returns an investor would receive over a period of time if they assumed “no risk”. While there is no real risk-free investment, investors often calculate the risk-free rate by subtracting the inflation rate from the yield on the Treasury bond that is the length of your investments.
The market risk premium is calculated by subtracting the risk-free rate from the expected returns of the market as a whole. Investors often calculate the expected return of the markets using major indices such as the S&P 500. The market risk premium will tell the investor the excess return they can expect for the additional risk they assume by investing. in this market. Multiplying the market risk premium by the beta of a stock or other asset tells the investor how far they can expect the stock or other underlying asset to exceed the risk-free rate he could earn elsewhere.
The investor adds the risk-free rate into the equation to calculate the expected return. By adding this rate, the investor increases his expected return to take into account the additional risk he takes. This means that companies with lower betas will assume lower expected returns because the risk-free rate they add carries more weight. Conversely, the risk-free rate will be proportionately lower when it comes to a higher beta.
The expected return on an investment calculated using the Fixed Asset Valuation Model is a popular and widely accepted model, however, the CAPM has underlying assumptions which are not always true in reality.
A major assumption in CAPM is that it assumes that the risk-free rate of return will remain constant over the course of the investment. Both increases in Treasury yields and decreases in inflation can make the underlying assets appear overvalued, while the reverse of the aforementioned changes can cause the investment to be undervalued.
As with any model that uses the beta of a stock for risk, CAPM also assumes that the risk of the stock can be measured by the volatility of a stock’s price. This assumption is inherently wrong because positive and negative price movements are not equally risky.
Despite the flaws of the underlying assumptions found in the CAPM, this model is popular with investors because they can easily compare the potential returns of various investment opportunities to find the right one for them. One of the ways that investors use the CAPM is a discount rate in the present value formula to calculate the value of a future investment today. The underlying asset would be considered undervalued if the price of the investment today is less than your calculated present value.