Capital Asset Pricing Model as Means of Valuing Securities and Their Risk - Essay Example

Outline and discuss the Capital Asset Pricing Model (CAPM) as means of valuing securities and their risk. What are the drawbacks with the CAPM and how does it compare and interact with the dividend valuation model? Introduction Capital Asset Pricing Model (CAPM) is a quantitative tool for analyzing the return of a particular security with the risk associated of that particular security with respect to the overall market risk (Ashbaugh and Pincus, 2001). This model was presented by William Sharp in 1964. This model was considered as a revolutionary piece of work in the modern portfolio theory presented by Markowitz such that William Sharp, Markowitz and Miller were awarded with the Nobel Prize in 1990 for their contribution to the study of finance (Shim and Siegel, 2008). Some other financial experts like Lintner and Mossini also explained and purified CAPM and its interpretation in later years (Gassen, and Sellhorn, 2006). Capital Asset Pricing Model Being a quantitative tool for computing the yield of a security, CAPM is used for pricing the financial asset through mathematical calculations (Fields and Vincent, 2001). There are three main components of CAPM model which are stated as follows: Rf = Risk-free rate Beta = Risk of individual security with respect to market Rm – Rf = Market Risk Premium Risk-free Rate Risk free rate is considered as the rate at which the investor does not face any risk yet he obtains a specified return. This risk-free return can be obtained by investing in government securities which are considered are risk free. However, the term risk-free is referred to only the risk related to default risk. Since governments are considered as the ones which are not supposed to face default risk, therefore, their securities are considered as risk-free securities (Babu, 2012). Beta Beta is the factor which indicates the risk of a particular security associated with the overall market risk (Vishwanath, 2007). There are two types of risks which an investor faces i.e. Systematic risk (non-diversifiable risk or market risk) and Unsystematic risk (diversifiable risk). Systematic risk is the risk of the overall economic activity of the country. For example, change in the tax rate, interest rate, macroeconomic data, legislation and regulations etc. This is the risk which is beyond the control of an investor as well as the corporations whose securities are being traded in the capital market. This risk is called as the overall market risk such that the whole market is exposed to that risk and bears its consequences (Berk and DeMarzo, 2010). On the contrary, unsystematic risk is the risk related to a specific security such as downfall in the earnings, or slow growth, heavy fine etc. This is the risk which does not affect the market and can be eliminated through diversification by adding more securities in the portfolio. Market does not reward unsystematic risk of a particular because this risk can be eliminated through diversification. But it does reward the systematic risk as this risk is faced by every security simultaneously in the whole market (Watson and Head, 2009). In a more concise manner, beta is the measure of systematic risk of the individual security with respect to market risk. In other words, it tells how much volatile an individual security is with the market volatility. Beta of the overall market is 1. So if the beta of the individual security exceeds 1, it means that the security is having more risk as compared to market risk. On the contrary, if the beta is less than 1, it means that the security is having less volatility as compared to market risk. A risk taker invests in those securities which have a beta of greater than 1 whereas a risk averse investor tends to remain at a safe side and invest in those securities which have a beta lower than 1. Market Risk Premium Market risk premium is actually the difference between the overall market return and the risk free return (Brigham and Ehrhardt, 2010). In other words, it is actually the excess return that market provides above the risk free return. Market risk premium denotes the return which is demanded by an investor having completely diversified portfolio. This is the return which is offered by the market in excess of risk free return by facing a given risk. In order to bear a certain risk, the market rewards the investor with excess market risk premium. From the point of CAPM, market is includes a capital market in which the debt and equity securities of the corporations are traded as well as the securities which are over the counter. Not only this, real estate, human capital, consumer items, etc. are also included in the definition of market. However, it becomes very difficult to calculate the overall return of that market. In order to overcome this problem, proxies are used which are representative of a market (Jaffe and Ross, 2004). For instance, Dow Jones Industrial is a representative of return of 30 corporations listed in New York Stock Exchange (NYSE). Similarly, S&P 500 index is the representative of 500 US corporations. Other examples include FTSE 100 for UK companies, CAC 40 for French companies and DAX 30 for German companies etc. The market return is computed by the weighted average of total market capitalization of the divided the by base year’s market capitalization (Baker and Martin, 2011). The actual computation takes into account of various other factors as well like the impact of dividends and stocks splits etc. Following is the equation for CAPM model: E (Ri) = Rf + B ( Rm – Rf) From the above equation, it can be noted the required rate of return of a particular security is the linear function of risk free return and the market risk premium pertaining to that particular security (as indicated by the beta of that security). In the above equation, risk-free rate (Rf) is the intercept and market risk premium (Rm – Rf) is the slope. This equation is also known as Security Market Line (SML) when drawn as a graph. Assumptions of CAPM Capital Asset Pricing Model has some assumptions that should be taken into considerations because CAPM is based on these assumptions. 1. No transaction costs are involved in the trading of these securities. 2. Divisibility of the assets in the portfolio is indefinite. 3. Income taxes are not collected in the economy. 4. Prices of the securities are not affected by anyone’s operations. 5. Decisions made by the investors are based only upon the expected risk and their returns i.e. rationale decision making. 6. Short-selling of the securities is not allowed. 7. Borrowing and lending in risk-free securities is unlimited. 8. Time horizon for the investment is same for all investors. 9. Same inputs are used by all the investors i.e. return, risks and correlations etc. 10. Every asset is traded in the market having some price. Shortcomings of CAPM Following are some of the shortcomings related to CAPM 1. CAP has some very restrictive assumption such as rational decision making, no transaction cost or no income taxes etc. whereas these assumptions are not realistic. 2. Empirical evidence and support of CAPM is not possible such that its test cannot be conducted. 3. Only factor i.e. risk of a particular security is assumed in CAPM. Despite of the shortcomings of the model, there are various advantages of CAPM model such that this model is easy to understand, easy to apply. However, researchers have found out that the main reason behind less empirical support of this model is due to the problem in data sets as well as stationarity of the beta. It is important to note that volatility of a particular security is not the only indicator of the riskiness of the particular security. Due to having many assumptions i.e. assumptions of efficient market, CAPM model is not closer to realistic view The fair value of the financial asset determines the overall return of the market. However, if the value of the financial assets is determined through computations of CAPM model, in that case there would be no market at all. CAPM and the Alternative Theories Arbitrage Pricing Theory Unlike CAPM model which solely considers risk as the determining factor for the return of a specific security, arbitrage pricing theory takes into consideration all the macroeconomic factors that can contribute in the determining the return of a particular security. CAPM and Dividend Valuation Model Dividend discount model is the first authenticated, easiest and most reliable method of determining the price of a security i.e. stocks. Under dividend valuation model, the expected dividends of the upcoming years of a corporation are estimated and then discounted by the appropriate discount factor of the firm in order to obtain the intrinsic value of a stock. Under indefinite life of a corporation, where the dividends are expected to come till perpetuity, the upcoming dividends are discounted by cost of equity which is determined through CAPM in order to achieve the intrinsic value of a security. The intrinsic value of a security is then compared with fair market value of that stock. In case if intrinsic value is turned out to be less than the fair market value of the stock, the stock is said to be over priced and the analysts suggest that security should be sold out or should not be bought due to be overpriced. On the contrary, if the intrinsic value is greater than the fair market value of the stock, then that security is considered as underpriced and the analysts believe that the security should be bought, or held if it is already included in the portfolio of the investor. Dividend Discount Model (DDM) works on the principles which are followed for the valuation of bonds. DDM also takes into account a definite investment horizon for a stock to be kept in the portfolio. However, it becomes very hard to exactly determine the time period for which the stock is held unlike bonds for which the maturity period is definite and already specified. DDM discount model face the problem estimation of the price at the end of the investment timeline. This can be referred as one of the weaknesses of the DMM. Even though DDM is based solely upon the dividend estimation over a defined horizon of investment, still there are problems associated with this model. For instance, it is not necessary that a firm always distribute dividends. Apple Inc. has the strategy of reinvesting all the profits in the times of Late Steve Jobs, the former CEO of Apply Inc. However after him, the company changed this strategy and started paying off the dividends. In that case, it was impossible to determine the intrinsic value of Apple Inc. with the application of DDM. On the contrary, some firms struggle with their earnings. In order to keep the confidence alive for their investors, they distribute dividends somehow. On the basis of those dividends, if the intrinsic value of the firm is computed, it would not be considered as reliable because of the irrational distribution of dividends of those companies having other objectives (Eckbo, 2008). For estimating the future value of dividends, Gordon provided a growth model such that dividends received last year are compounded with a constant growth rate. In this way all the future values of the dividends can be estimated and then they can be discounted by the difference between the cost of equity and growth rate in order to estimate the intrinsic value of the firm (Bierman, 2003). Dividend Discount Model fails to estimate the intrinsic value of the firm which has some other objectives. For instance, in case if a firm is having losses, then how to value that firm on the basis of DDM, the mystery is still unresolved as the company does not have any earnings to distribute (Khan, 2004). In a nutshell, it can be stated there are some better techniques in order to compute the intrinsic value of the firms such Discounted Cash Flow Method, Price to Earnings Methods etc. References Ashbaugh, H. and Pincus, M., 2001.Domestic accounting standards, international accounting standards, and the predictability of earnings. Journal of Accounting Research, 39(3), pp. 417–434. Babu, G., 2012. Financial Management. New Delhi:Concept Publishing Company. Baker, H. Kent . and Martin, Gerald S., 2011.Capital Structure and Corporate Financing Decisions: Theory, Evidence, and Practice. New York: John Wiley & Sons. Berk, Jonathan B. and DeMarzo. Peter M., 2010. Corporate finance. 2nd ed. New York: Prentice Hall. Bierman, Harold., 2003. The capital structure decision. New York: Springer. Brigham, Eugene F. and Ehrhardt, Michael C., 2010. Financial management: theory and practice. 12th ed. New York: Cengage Learning. Eckbo, Bjørn Espen., 2008. 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