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Consider Stock A and Stock B in the same industry with similar cash flows, similar growth expectations, similar business structure and similar capital structures - both trading at a market price of Rs 548. As with everything else in this example, PE is the same, PEG is the same (to understand more about PE and PEG, Click Here). Let us say that both stocks are trading at a PE of 15, which corresponds to the long term average PE multiple of this industry. To most investors, both stocks would appear fairly valued. But savvier portfolio managers may look at one more vital angle to help them discern which stock is a better fit into their portfolios - which stock adds more value to their portfolios.
This is where Capital Asset Pricing Model (CAPM) plays a role in helping us to calculate the fair value of the investment. It helps us to calculate investment risk and what return we should expect on our investment. It serves as a model for the pricing of risky securities. More importantly, it helps portfolio managers understand whether an addition to their existing portfolio adds value to the overall portfolio or detracts value. The key to this is to first understand the level of risk in a particular stock, determine the expected return that justifies this level of risk and then determine whether this incremental stock in the portfolio can deliver this expected return or not.
To understand the CAPM model, we need to first understand the risks in the investment. The model considers individual investment have two types of risks:
1. Systematic Risk - These are risks that cannot be diversified away. This type of risk is unpredictable and cannot be completely avoided. It is also called market risk or non-diversifiable risk. Interest rates, inflation, recessions and wars are examples of systematic risks.
2. Unsystematic Risk - Also known as specific risk, this risk is unique to an individual asset. It is the risk that something can go wrong on the company or industry level, business risk, financial risk, other risks, related to investment into particular asset. It represents the component of a stock's return that is not correlated with general market moves.
Unsystematic risk can be diversified away by holding many different assets in the portfolio. However diversification still doesn't solve the problem of systematic risk. Even a portfolio consisting of all the shares in the stock market can't eliminate this risk. Therefore, when calculating an expected return, systematic risk is what worries investors the most. CAPM, therefore, was introduced as a way to measure this systematic risk.
The linear relationship between the return required on an investment and its systematic risk is represented by the CAPM formula,
ra = rf + ßa (rm - rf)
where:
ra = the expected rate of return on an asset
rf = the rate of return for a risk-free security
rm = the broad market's expected rate of return
ßa = beta of the asset
CAPM starts with the risk-free rate. Generally, 10-year government bond yield proxies risk free rate. The market rate of return can be assumed as average market return for sufficiently long periods of time - say 10-20 years. To this is added a premium that equity investors demand to compensate them for the extra risk they accept. This equity market premium consists of the expected return from the market as a whole over the risk-free rate of return. This equity risk premium is multiplied by a "beta."
According to CAPM, beta is the only measure of a systematic risk. Since specific risk can be diversified away, no premium should be given for it. Hence, the specific risk should not be considered when evaluating the risk-return performance of the stock and so the beta becomes the crucial point for the risk-return analysis of the stock. It measures relative volatility of a security or a portfolio in comparison to the market as a whole. It shows movement of a stock relative to the general market movements. A beta of 1 indicates that the security's price will move with the market. A beta of less than 1 means that the security will be less volatile than the market. A beta of greater than 1 indicates that the security's price will be more volatile than the market. In other words, Beta shows the amount of compensation equity investors need for taking on additional risk.
Most investors use a beta calculated by a third party, whether it's an analyst, broker or other vendors.
If the stock's beta is 1.5, the risk-free rate is 8% and the market rate of return is 15%, then expected return is calculated as follows:
Exp return= 8% + 1.5 (15% - 8%) = 18.5%
This shows that a riskier investment should earn a premium over the risk-free rate. The amount over the risk-free rate is calculated as the equity market premium multiplied by its beta.
Practical Implication
This model presents a very simple theory that delivers a simple result. The theory says that an investor should earn more, by investing in the stock that is riskier. There is value in its simplicity and ease of application. Though CAPM's validity is questioned, the model is still widely used in the investment community
CAPM is most often used to determine what the fair value of an investment. Using CAPM, one can calculate the risky asset's rate of return and then that rate can be used to discount the investment's future cash flows to their present value and thus arrive at the investment's fair value. After calculating the investment's fair value, one can then compare it to its market price. If your price estimate is higher than the market's, you could consider the stock to be undervalued. If your price estimate is lower, you could consider the stock to be overvalued. In other words, by knowing the individual inputs of the CAPM, it is possible to determine whether or not the current price of a stock is consistent with its likely return, or whether the investment is undervalued or overvalued.
Lets get back to our example
Equipped with these insights on CAPM, lets now get back to our example of stocks A and B. A seasoned portfolio manager will, in addition to all the fundamental parameters discussed at the outset of this article, also make the effort to ascertain the betas of both stocks. Remember, higher beta typically denotes higher risk and therefore warrants higher expected return to justify this incremental risk.
He determines that stock A has a high beta of 1.8, while stock B has a much lower beta of 0.7. Can such a wide gap exist if both businesses are similar? Perhaps on fundamentals, such a large gap may not be warranted, but typically if Stock A is a speculator driven stock, it might well see a much higher beta, even if the business profiles are similar.
Now, lets look at how a portfolio manager who uses CAPM will value both these stocks. A key input here, as we discussed, is the expected rate of return. In both cases, we assume market return at 15% and risk free return at 8%. Expected return as per the CAPM model is calculated as
Risk free return + Beta (Market return - risk free return).
For Stock A, expected return will be 8% + 1.8(15 - 8) = 8% + 12.6% = 20.6%
For Stock B, expected return will be 8% + 0.7(15-8) = 8% + 4.9% = 12.9%
If these are the expected rates of return, what we need to do is to apply DCF (discounted cash flows) to determine the fair value of both stocks at today's prices - ie, discount the future cash flows using the two expected rates of return to determine today's fair value (for more insights into DCF, click here)
Here's how both companies now stack up, after using CAPM as an additional valuation tool :
We now observe that though the earnings and business profiles of both companies is similar, Stock A's fair value is significantly lower than Stock B's fair value. This is the impact that the beta - or market risk, or volatility - plays in determining fair value of a stock. If both stocks are trading at Rs. 548, we can now say that Stock B is undervalued while Stock A is overvalued. In other words, given the huge volatility of Stock A in the market, equity investors will have a much higher return expectation from Stock A as compared to Stock B - and the current price is too high to meet these higher return expectations.
Conclusion
While you might receive high returns from high beta shares, there is no guarantee that the CAPM return is realized. Though CAPM is not a perfect theory, it provides us with a measure of risk that helps investors determine what return they should expect for putting their money at risk. Until something better presents itself, however, the CAPM remains a very useful item in the financial management tool kit.
Using the concept of risk-free returns and beta, the CAPM is used to compute the expected value of a prospective investment. If the investment is being sold for less than the computed expected price, it is a likely candidate for inclusion in the portfolio.
Share your thoughts and perspectives
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