Capital Asset Pricing Model

Part 1, March 2, 2021

The value of an asset is the present value of the expected cash flows on the asset, which is estimated by using a discount rate.

Discount rate represents the riskiness in the cash flows.

Most of the times, investors make their investment decision in assets that earn a return greater than the riskiness, also known as hurdle rate.

Most commonly used approach to estimate the riskiness of the assets is Capital Asset Pricing Method (CAPM)

Return of asset = Risk free rate + Beta times equity risk premium + company specific risk premium

More about estimating Beta:

The standard procedure for estimating betas is to regress stock returns (Rs) against market returns (Rm) - Rs = a + b Rm

When we put stock return on Y axis and Market Return on X axis, "a" will represent the point where regression line crosses the Y axis and the slope of the regression represents the beta of the stock, and measures the riskiness of the stock.

Key points to consider while estimating beta:

1. Estimation period, 2 years or 5 years
2. Return interval - daily, weekly, monthly
3. Choosing market index

Stay tuned for deeper dive on each of these considerations.

#equities #investment #financeandeconomy #businessvaluations #costofequity

Go Back to Main screen