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Is CAPM a Good Method to Calculate Cost of Equity?

Original post by Cynthia Hartman of Demand Media

CAPM helps investors estimate portfolio returns.

The capital asset pricing model (CAPM) formula says an investor's required return equals the risk-free rate, plus a premium for additional risk. Investors and analysts use this formula to calculate the cost of equity, or the required return they need to make investments in a portfolio, individual stock or other assets that grow in value over time. Other methods are used for this same purpose, although each has its own benefits and shortcomings.

CAPM Defined

CAPM provides a formulaic method to model the cost of equity, or risk-return relationship of an investment. It helps users calculate the cost of equity for risky individual securities or portfolios. Investors need compensation for risk and time value when investing money. The first part of the CAPM formula uses the risk-free rate to represent investors' compensation for time value. The rest of the CAPM formula calculates the additional return the investor needs to take on certain levels of risk. CAPM combines beta, or average returns on specific assets as compared to the market, with the premium investors expect for carrying risky investments.

Systematic Risk

The CAPM formula has remained in wide use for over 40 years because it has several advantages over other methods used to calculate a required return. One of the most important reasons is that CAPM considers only systematic risk. This reflects the reality that diversified portfolios have essentially eliminated all unsystematic risk stemming from individual asset investment characteristics. Systematic risk is risk that can't be diversified away -- it is inherent to the entire market or a market segment.

Empirical Testing

CAPM's demonstrated relationship between systematic risk and required return has been able to withstand frequent testing and empirical research. Because CAPM considers a company's systematic risk compared to the risk of the overall market, it improves upon other methods for estimating returns, such as the dividend growth model. The dividend growth model is not useful for companies that do not pay dividends. The dividend growth formula also assumes dividends grow at a stable rate forever, and does not directly consider risk.

Weaknesses

CAPM has some issues because of the quality of the formula assumptions. The risk-free rate, or yield on short-term government debt, changes daily. An average rate should be used to smooth results. Risk premium values also present a challenge. The stock market return, or the sum of the average capital gain and average dividend yield, may be negative in the short-term. Analysts mostly use long-term risk premium averages from research publications, but the risk premium has been found to be unstable over time. Uncertainty regarding the risk premium leads to uncertainty regarding CAPM's results. Beta information is published for public companies, allowing analysts to factor it into the CAPM formula. However, beta also changes over time, introducing more uncertainty.

                   

References

About the Author

Cynthia Hartman started writing in 2007 and has written for several different websites. She brings more than 20 years of experience in finance and business ownership. Hartman holds a Bachelor of Science in finance and business economics from the University of Southern California.


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