CAPM – What is the Capital Asset Pricing Model

the capital asset pricing model often
called CAPM for short is an investment theory that shows the relationship
between the expected return of an investment and market risk to better
understand CAPM I think it will be easier if we look at an example and how
it can be used this is the formula for CAPM and if you are of the math
persuasion then perhaps this formula makes a lot of sense but for the rest of
us let's break it down to try to make it a bit simpler so there are only three
inputs that go into CAPM. first is the risk-free rate we're going to use the
10-year Treasury note and as of now it's September of 2018 the 10-year Treasury
note is about 3% next we have beta. beta looks at the relationship between our
investment and the market for our example we will use a stock so for us
beta looks at how the stock moves compared to how the stock market moves
the market by definition gets a beta of 1 so let's use Apple stock so we can see
an actual example so apples beta is 0.99 and this is
mighty close to 1 so what does this tell us
well it tells us that Apple's stock acts very similar to the market so if the
markets up 1% well then Apple stock will be up almost 1% more exactly it should
be up about 0.99% same is true on the downside the market goes down Apple
stock will be down just short of 1% and just to see how this impacts things
let's throw a second stock in there right now Facebook has a beta of 1.2 so
if the market moves up or down 1% Facebook will move up or down 1.2% the
closer the beta is to 1 the more the stock moves like the market does the
final input in our formula is the expected return of the stock market now
coming up with this number isn't always clear some research companies publish
what they expect long term market returns to be you can also use a
historical average for our case we're going to use the average of the past 10
years which is about 9% per year ok so now we have all of our inputs our
risk-free rate is 3% beta for Apple is 0.99 and for Facebook its 1.2 and then
we have the expected market return of 9% okay so let's plug these numbers in so
Rf is the risk-free rate so here we could plug in 3 percent this symbol here
this is the Greek symbol for beta for Apple we can replace this beta with 0.99
and we could put Facebook's formula down here and there we will put 1.2 then in
the parenthesis we have the expected market return minus the risk-free rate
they call this the market premium for the expected market return we're using
nine percent and for the risk-free rate it's the same as the three percent that
we're using over here now for those interested the horizontal bar that's
above the R right here and here well that bar indicates that this is an
estimate so now we know we're using an estimate of expected market return and
that will give us an estimate of the return of this asset that's what the
lowercase a stands for and over here M that stands for the market so when we
calculate these we end up with eight point nine percent for Apple and ten
point two percent for Facebook now don't forget the only difference
between Apple's formula and Facebook's formula is their individual beta so how
can this be used well one way you can use CAPM is to use it in calculating
the WACC of a company WACC is short for weighted average cost of capital and
that WACC can be used as a discount factor to value a stock in something
like discounted cash flow now technically for WACC you would use both
the cost of debt and the cost of equity CAPM can be used as the cost of equity
so for a quick illustration as to how it can be used let's imagine that Apple and
Facebook have no debt which means that whack for both of them is the same as
CAPM let's see how that would play out let's imagine that we had an expected
cash flow coming from Apple in two years and let's imagine that it is going to be
$1,000 well since cash is more valuable today than it is in let's say the two
years well what we can do is use the results of our CAPM calculation as a
discount factor so if I'm gonna get $1,000 in two years well for Apple using
our CAPM results of eight point nine four percent we can use that as a
discount factor and we can see that that $1000 in two years is worth eight
hundred and forty two dollars and 61 cents today for Facebook if we were also
expecting a thousand dollars in two years that
be worth eight hundred twenty three dollars and forty three cents today so
in theory that's the present value of your future cash flow expectations so
what you want to do is pay less than that today and if your expectations are
correct well the bigger the gap between what you pay today and your calculated
present value the bigger your returns will be now CAPM isn't the only way to
calculate a discount rate or an expected rate of return there's also something
called the arbitrage pricing theory that's quite popular there are also a
few multi-factor models at work as well so keep in mind that CAPM is one of a
few choices not the only choice at some point in the future I'll do similar
style videos to this on the arbitrage pricing theory and multi-factor models
and if you haven't done so already hit the subscribe button and I appreciate
you staying with the video all the way to the end thanks and I'll see you in the
next video

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