“Remember that time is money.” -Benjamin Franklin

“Some investments do have higher expected returns than other. Which ones? Well, by and large they’re the ones that will do the worst in bad times.” -William Forsyth Sharpe

Source: UniversalCPAreview.com

The Capital Asset Pricing Model was largely developed by William Forsyth Sharpe, the namesake of the Sharpe Ratio which measures risk-adjusted return. Put simply, the CAPM is one of the cornerstones of modern financial theory and is used extensively in practice to estimate the vital discount rate for discounted cash flow models. The model breaks up risk into two categories: market risk and risks unique to the stock. The all-important Sharpe ratio, or risk-adjusted return is at the core of successful investment and measures not the return of an investment, but the return of an investment relative to the market risk. Crucial to CAPM is a question. What is the opportunity cost of investing in one asset compared to another opportunity?

The risk-free rate is key to the formula. It shows what investors would receive for a zero-risk investment and thus serves as a vital comparison tool. How much are you getting compensated for the risk you are taking? This question is central to the goal of the model. To answer it you need to understand what you’ll get for not taking any risk. Beta measures returns relative to the market. We discuss the concepts of Alpha and Beta more extensively here in our guide on Investor Psychology.

Beta is the return of a security relative to the market. If an investment has a beta above 1 then it has greater volatility then the market, if it is less than 1 then it is less volatile then the market. An investment with a beta of one would have the same volatility as the market.

The market risk premium is the additional return you are getting by being invested in a particular security versus what you would earn in a risk-free asset. Crucial to the operation of this model are many assumptions including the assumption that a stock which has been more volatile in the past is likely to continue being volatile relative to the market. The CAPM is crucial to determining the Cost of Equity, which in turn is essential to determining the Weighted Average Cost of Capital if the company is leveraged. If the company is unleveraged then the Cost of Equity alone will suffice.  

Source: eFinanceMangement.com

One advantage of the CAPM is that it is pretty simple and easy to implement. However, some of the cons come into play with regard to the assumptions it rests on, which some deem as overly simplistic and of limited utility in the real world. Regardless of where you fall on the theoretical nuances of the underpinnings of this theory understanding it and being able to use it to successfully estimate a discount rate are crucial to equity analysis.