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Understanding The Capital Asset Pricing Model (CAPM)

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Capital Asset Pricing Model (CAPM)

Understanding the Capital Asset Pricing Model (CAPM)


Investors expect to be compensated for risk and the time value of money.
The risk-free rate in the CAPM formula accounts for the time value of money.
The other components of the CAPM formula account for the investor taking on
additional risk.

The beta of a potential investment is a measure of how much risk the investment


will add to a portfolio that looks like the market. If a stock is riskier than the
market, it will have a beta greater than one. If a stock has a beta of less than
one, the formula assumes it will reduce the risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium, which is the return
expected from the market above the risk-free rate. The risk-free rate is then
added to the product of the stock’s beta and the market risk premium. The result
should give an investor the required return or discount rate they can use to find
the value of an asset.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued
when its risk and the time value of money are compared to its expected return.

For example, imagine an investor is contemplating a stock worth $100 per share
today that pays a 3% annual dividend. The stock has a beta compared to the
market of 1.3, which means it is riskier than a market portfolio. Also, assume that
the risk-free rate is 3% and this investor expects the market to rise in value by
8% per year.

The expected return of the CAPM formula is used to discount the expected
dividends and capital appreciation of the stock over the expected holding period.
If the discounted value of those future cash flows is equal to $100 then the
CAPM formula indicates the stock is fairly valued relative to risk.

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