How to value stocks using the fixed asset valuation model


Investing in yourself is a risky proposition and if you decide to accept it without a good knowledge of the risk and reward involved, it can amount to a blind person fumbling around.

To make informed decisions, investors can subscribe to reports from a reputable investment firm or to advice from a trust broker. Some may even prefer to trust their instincts after gaining a “feel” for market psychology due to the fact that they have been in the business for a long time.

While all of the above are legitimate practices, described below is a more scientific DIY technique. While it might seem as foreign as a foreign language at first, taking the time to understand the theory and put it into practice can help familiarize investors with this DIY model.

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The Capital Asset Pricing Model, or CAPM, is a model used for:

  • Calculate the expected rate of return on an asset taking into account knowledge of the risk associated with the asset.

  • Calculate the cost of capital.

  • Determine the price of a risky asset.

Logic behind the model

The returns received are a direct function of the risk taken. The higher the risk you take, the greater your returns.

The formula

ra = rrf + Ba (rm-rrf)

Essentially, the expected return is equal to the return on a risk-free asset plus a risk premium.

where ra – required rate of return for an asset

Ba – the risk coefficient of the asset

rm – expected market returns

Now for the values ​​of each of the metrics on the RHS of the equation:

  • Treasury bills, which are relatively safe investment options, are considered risk-free assets. Thus, the yields of Treasury bills / bills of appropriate maturity depending on the time horizon of our investment are used for the purpose of calculating the returns of a risk-free asset.

  • The returns of the S&P 500 Index or any other credible representative index could be used to calculate expected market returns.

  • That leaves us with beta, which measures volatility. One can use the beta values ​​provided by reputable analysts or websites or calculate them personally, the second option being tedious.

  • A security with beta> 1 is more volatile than the market and therefore risky and on the contrary, one whose beta is

An example

Assuming the risk-free return is 5% and the market return is 8% and the beta of the asset is 1.5, the expected rate of return on the asset can be calculated using the using the CAPM model.

Expected return on assets = 2 + 1.5 * (8-2)

= 2 + 9

= 11%

Good investment, guys!

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