Capital Asset Pricing

Capital Asset Pricing MarginDate Added: May 16th, 2004

By Dan Schuster | E-mail

From the NFL draft to fast food value menus to Wall Street, the illusive term of "value" is used everywhere. By definition, something with a good value produces a high return in comparison to what you had to give up in order to acquire it. In terms of the stock market, investors are always trying to find stocks that are undervalued, meaning their current market price is less than what they are "really worth." The only problem is that it is next to impossible to determine the value of something until after its acquisition. For example, Ryan Leaf certainly wasn't a good value for the Chargers with the number 2 pick in the 1998 draft, and a stock with a low PE ratio can turn out to have terrible returns. So how does one determine the value of a stock? Simple...just call up the next psychic you see on one of those late night infomercials, or you could try using the Capital Asset Pricing Model (CAPM).

The CAPM is one of just many techniques that investors can use to find the intrinsic or real value of a stock. This model follows the basic premise that investors should be rewarded for taking excess risk, and that equities face two types of risk: market risk and unique risk. The CAPM only considers market risk in the valuation of securities because it is the risk associated with the movement of the entire market as a whole, and unlike unique risk, it cannot be diversified away.

Calculating Expected Return using CAPM

First, you need to find the beta of the security you are trying to value, which we will call security k in this example. You can usually do this by looking up a stock on Yahoo! Finance. Next, you simply plug the beta of k, noted by symbol B_k into the following equation:

ER_k = r_f + B_k (ER_p - r_f) where:

ER_k is the expected return on the stock for the year

r_f is the risk free rate of return

B_k is the beta of stock k

ER_p is the expected return on the market portfolio (typically the S&P500)

While this may seem extremely complicated at first glance, it really isn't at all. In fact, B_k is the only real variable. The risk free rate of return, using the sensible assumption that the United States government won't default, is simply the return on a 30-year T-bond, which is typically around 6%. The expected return on the market portfolio can be estimated using the fact that the market has averaged a 12% return historically, or it can be estimated using analysts' estimates for the coming year. Thus, the equation simply becomes:

ER_k = .06 + B_k (ER_p -.06)

After you have calculated the expected return of the stock in question, it is very simple to make some conclusions as to whether or not you should invest in that stock. For example, if ER_k < ER_p, you may not want to invest in the stock because even if it will make you money, stock k will have a lower return than the market, and therefore, the money could be better invested elsewhere. On the other hand, investors should remember that a high expected return also implies a high risk of a negative so investors shouldn't rush into an investment based solely on the CAPM. Either way, it gives you a starting point in valuing the stock, and as Oscar Wilde stated in Lady Windermere's Fan, a cynic is "a man who knows the price of everything and the value of nothing."