The CAPM cost of capital model requires no introduction. It is used by business appraisers, savvy investors, and even the general public on occasion. Ask your friendly securities broker about betas. You will be regaled with a list of investment prospects with different levels of risk and return, along with the beta number for each company.
The beauty of the CAPM model is its simplicity. In formal math terms, it is a linear function. You can use it to calculate a company’s expected rate of return based on the market-wide figures of risk free rate of return and equity risk premium.
Security market line
The CAPM linear function establishes what is known as the security market line or SML for short. If you are valuing a company, you may have heard about the capital asset pricing theory.
The risk-free rate of return means that you will receive this return on investment and get your investment back on time. Think US Treasury yields as a good proxy for this.
If you want to invest in highly diversified portfolio of public company stocks, you take an additional risk. Investment gurus call this the equity risk premium or ERP for short. What does it mean? That your stock investments carry greater risk, no matter how much you try to diversify.
Now picture a coordinate plane on a piece of paper. The y-axis shows the returns, while the x-axis shows the risk in the form of beta. The straight line SML starts at the risk-free rate and hits the ERP when beta equals 1. That’s the volatility or risk of the equities market as a whole.
For any specific company, you should figure out the beta. Now examine the stock returns over time. Any estimate of return that falls off the security market line essentially misprices the business.
Overvalued and undervalued stocks
So if the returns land above the SML, you should view the stock as undervalued. On the other hand, the stock is overvalued if the actual returns fall below the SML.
In a fully efficient capital market all company expected returns should fall on the SML.
Valuing businesses: risk and return
In other words, investors would require rates of return from companies based on the level of risk they represent as investments. If a given business is undervalued, investors will pile their money into it until the price per share rises. On the other hand, no reasonable investor would hold on to the stock of a company that is overpriced. Not for long anyway.
In the public capital market, stock prices adjust. Eventually the rate of return gets high enough to compensate the investors for the risk they take. In other words, company valuations place the expected rates of return on the SML, sooner or later.
Comparing your company’s beta to the market
If you study the market as a whole, the beta is equal to one. So what does it mean if your company’s beta is different than one?
Do you reckon your company’s beta to be greater than one? Then its rate of return moves up or down to a greater degree than the market. If you have the nerves to face the roller coaster of high tech investments, you must enjoy high rewards or crushing losses.
What if the company’s beta is positive but less than one? It means that its actual rate of return tends to fluctuate with the market but to a lesser extent. Low risk companies such as risk averse utilities are a good example.
Ever see a company with a negative beta? Its returns tend to move out of sync with the market. A classical example are minerals companies such as those in the precious metals industries.
This illustrates the power and simplicity of the CAPM cost of capital model. You can figure out the expected returns for your investment based on just two factors:
- Risk free rate of return.
- Market-wide equity risk premium.
Your beta estimate for the company completes the picture.