The realm of finance can be encapsulated in a theory widely known as CAPM. I still vividly remember the first time I was introduced to the concept of CAPM (phonetically pronounced CAP-M). Unlike my prominent and industrious counterparts in the financial services industry, I believed that CAPM was an abridged referral to the capital markets. In retrospect, I can only marvel at my naivety and attempt to elucidate the crux of this model for you.
What is CAPM?
CAPM stands for the Capital Asset Pricing Model. In order to truly understand CAPM, one must begin by understanding the time value of money. Let’s begin with the rudimentary and tested method of exemplifying this concept. If I were to ask you to pick between receiving $1 today versus a few days from today, the correct answer would be today. No, it’s certainly not because I believe in being greedy, it’s simply because setting aside inflation, you could invest the money today and earn interest or secure an asset that would generate returns in the future. If I assume that you did indeed take your $1 and compiled it with some extra cash to invest in the stock market, the compensation for investment risk you undertake will be calculated through CAPM. In other words, since you decided to invest your savings, the return your chosen company should give you, the equity investor, would be computed through CAPM.
How do u compute it?
The intangible world of numbers has the ability to transform something elusive to tangible, concrete returns: money. Likewise, CAPM can be computed via this mathematical formula: CAPM= RF + β * (RM-RF)
RF is the risk-free rate. The risk-free rate is essentially a sophisticated way of stating the following: What is the return you can earn on an investment that carries zero risk. Government securities are known to carry almost zero risk since the Federal Reserve can simply print more money at will if it does not have the capital to return your investment.
RM is the expected rate of return earned by investing in the markets. It is referred to as market return.
β is the stock beta. Click here to read more about it.
(RM-RF) represents the difference between the market return and the risk-free rate, informally referred to as the premium.
If you think about CAPM intuitively, you will arrive at the conclusion that the formula is the summation of risk and the time value of money.
How did you come up with that?
Back in the 1950’s, the phenomenon of portfolio theory was introduced to investors. Asset managers are always seeking strategies on constructing the ideal portfolio to hedge against market fluctuations while achieving strong returns consistently. CAPM aids managers that seek absolute returns by protecting their clients against systematic risk (ex: country risk). Diversification of portfolios is a relatively recent development. Let’s try to conceptualize the mathematics behind CAPM. What is a risk-free investment? Government securities and T-bills, right? This is the time value of money for your investment.
Let’s assume that you hear from your peers about the ability to generate more money through your existing savings. Tempting right? If you do happen to give into the promise of greater risk = greater returns, you will find some solace in CAPM by equipping yourself with the tools to evaluate whether your compensation in terms of returns will be worth the initial risk you undertake. If you invest your savings in a company, there will be an element of risk associated with the investment. For this risk, the company ought to compensate you by increasing the return it offers, i.e. the company will lure you in with a return that is equal (at the very least) to the risk-free rate of return (RF) plus an additional premium (RM-RF) for the risk (β) you are about to undertake. Still a little muddled by the mathematics behind CAPM? Continue reading!
Give me an example
It is often said that a picture is worth a thousand words. I for one could not disagree more. Simple mathematics should soon solve your problem.
If we assume that the risk-free rate (RF) is 2%, the stock beta (β) is 2 with an expected market return (RM) of 17%, the stock is expected to give you a 32% return.
CAPM = (0.02+2(0.17-0.02)) =0.32
Albeit unrealistic, these numbers are simply designed to shed some light on the computation of CAPM. The number derived from the computation above is in no means the concrete answer since a huge component, beta, is calculated based on your individual assumptions.
- Unlike the traditional way of investing (word of mouth, storing money in the bank, government securities) modern investors have invaluable tools such as CAPM to project returns they can expect over time to justify the initial risk of investing in a particular asset.
- Moreover, the applications of CAPM go beyond personal investment decisions. Investment banks often use CAPM to compute the Weighted Average Cost of Capital (WACC) that in turn, helps to compute the Discounted Cash Flow (DCF) model to quantify the value today of a series of expected cash flows.