What is CAPM? What does CAPM Tell Us?

What is CAPM & Why it Matters?

CAPM stands for Capital Asset Pricing Model. It is used to calculate the predicted rate of return of any risky asset. It compares the relationship between systematic risk and expected return. Typically, it’s used on stocks. However, CAPM can also be used throughout financial decision making to price riskier investments. When pricing them, it’s important to reach a balance between the price due to risk and the expected return – thus, using CAPM can help.

The main idea and impulse behind using CAPM is that investors need to be compensated for two things: the time value of money and the risk they are assuming. CAPM takes both into account.

Read: stock market definition

What Does CAPM Tell Us?

CAPM determines the fairest price for an investment, based on the risk, potential return and other factors. Calculating an investment’s price using CAPM helps establish a fair value of stock, while also giving investors a number to use when comparing to the stock’s current market value. If the estimate is higher than the current market value, then the stock is currently a bargain – but if it’s lower, then the stock is being overvalued.

CAPM gives you a good, comprehensive look at the risk versus rate of return on an investment, especially a stock. It’s a great tool to use when determining whether riskier assets are worth your investment.

How is CAPM Calculated?

So, how do you calculate CAPM? The formula for CAPM is this:

r_a = r_rf + B_a (r_m – r_rf)

In order to use this equation, you have to know what all of those variables mean. Here’s a quick breakdown:

– r_a is the needed rate of return in an asset

– r_rf is the rate of return on a risk-free security like U.S. Treasury bonds

– B_a is the beta of the asset (beta stock definition)

– r_m is the market’s expected return

Capital Asset Pricing Model and the Efficient Market Hypothesis

You will notice that the Capital Asset Pricing Model is very prescriptive, in the sense that it assumes that every asset has a beta that is easily calculated and this determines the expected return of the asset. Beta and the market rate of return describes every asset.

We have a different take on the beta risk as value investors

This is possible in the universe where every market participant acts from the same playbook. In effect, if the markets are rational.

CAPM makes the market efficient. And CAPM works if the efficient market hypothesis holds.

Although CAPM and EMH are two independent theories, they both rely on the 3 basic assumptions: investors are rational, all information is instantly reflected in asset prices, and, there are no transaction costs.

Risk and Expected Return and a Value Investor’s Take on These

Risk and return are broadly correlated in the stock market. Equity investors do require higher expected returns from the stocks that have higher perceived risk. However, the academic definition of risk relies heavily on the volatility of the stock.  CAPM formula depends on the beta of the stock. The investor psychology plays a defining role – what keeps investors up at night is considered risk. However, as value investors, we look at risk in a different way. For us, risk is defined as the probability of losing money on an investment. Volatility does not bother us, on the contrary, volatility often opens up temporary window for acquiring great stocks at great prices.

CAPM is not necessarily a consideration in evaluating value stocks. It does make sense to keep this in mind  as most of the market uses CAPM for their pricing and trading decisions and to construct fund’s investment portfolio. An equity analyst or investor will be remiss if their financial modeling does not consider the CAPM, however for value investors we evaluate individual stocks on their own merits with a backdrop of the overall market conditions. For value investors, expected return of a stock depends on the intrinsic value of the stock and the current market price. Beta of the stock is not relevant. Beta of the overall portfolio maybe relevant and it is likely that the rate of returns are correlated with the portfolio beta.

Other Considerations on CAPM and Beta as it Relates to Small Cap Stocks

Small cap stocks present further difficulties in proper application of CAPM. As you can deduce, beta is calculated based on the recent trading statistics of the given stock. For small cap stocks that do not have enough trading liquidity, the beta calculation is not statistically valid. Additionally, we have a fundamental disconnect between using beta (which is a measure of past performance) to predict the expected profits in the future (past performance should not reflect future performance). While Capital Asset Pricing Model is a good model to use on large cap and more liquid stocks, estimates generated using CAPM on small and illiquid stocks are not reliable. Financial markets are better off using different valuation models for estimating returns for smaller stocks.

At Value Stock Guide we believe that

1. Investors are not rational
2. Information is not readily reflected in the stocks, specially in low coverage small caps
3. of course there are transaction costs

As a result, while we agree that these are good theories to hypothesize how the market works, and to use them as some sort of an empirical model, these theories DO NOT adequately describe the functioning of the capital markets.

And therefore, while most investors have locked themselves up in the confines of these theories, we look for ideas and assets that continue to fall through the cracks. This is where value investing makes its presence known – where other investors do not tread.