Capital Asset Pricing Model, or CAPM in English, is a financial calculation model that measures the relationship between investors' expected returns and investment risks when investing. The CAPM model was proposed by the famous economist and scholar William F. Sharpe in his book "Portfolio Theory and Capital Markets" in the 1960s. CAPM is calculated by adding the risk-free return and risk premium of the investment, and its value represents the investor's expected return when investing. In the calculation process, the most important influencing factor is the β coefficient in the calculation formula, which is the system risk coefficient. Systemic risk refers to the risk inherent in the entire securities market, rather than the risk specific to a specific industry. Systemic risk is affected by factors such as national interest rates, economic development or recession, and war. It is a risk that investors cannot mitigate through portfolio diversification. In contrast, unsystematic risk refers to the risk that exists in a specific industry or company, which is usually affected by strikes in the industry, shortage of raw materials, or poor management of the company. The CAPM value is often used to calculate financial indicators such as the weighted average cost of capital (WACC) value and the discounted value of future cash flows. The full name of Rrf is Risk-Free Rate, which means zero risk return rate. The zero-risk interest rate usually matches the government bond interest rate of the country where the investment is made, and the bond period should also correspond to the time limit of the investment. However, in the investment field, the 10-year government bond interest rate is usually used as the zero-risk interest rate by default, because the 10-year government bond is usually the highest quoted and most liquid bond type. In the United States, the 10-year Treasury bond interest rate is also used as the zero-risk interest rate value. The current ten-year Treasury bond yield is 2.74% [source]. The full name of Rm is Expected Return of the Market, which refers to the expected return rate of the market. In the U.S. investment market, the average return rate of the S&P 500 is usually used as the market expected return rate. Calculated based on the historical return rate of the S&P 500, the average return value fluctuates around 10%, so 10% is usually selected as the market expected return rate. (Rm – Rrf) is called the risk premium, which is Market Risk Premium in English. It refers to the additional return for investors in addition to the risk-free interest rate. It is the return that must be provided to compensate investors for investing in risky products. The greater the volatility of a stock, the higher its investment risk, the higher the investor's expected return, and the higher the risk premium. The β coefficient is the systematic risk coefficient of a stock relative to the entire stock market. It is calculated using a specific calculation method based on historical stock returns. It measures the sensitivity between stock risk and overall market fluctuations. Its numerical significance is: β < 0: Stock investment risk is negatively correlated with market fluctuations; β = 0: Stock investment risk is not affected by market fluctuations; 0 < β < 1: Stock investment risk has a positive relationship with market fluctuations, and the sensitivity of the impact is low; β = 1: The risk of stock investment is equivalent to the market fluctuation; β > 1: Stock investment risks are highly sensitive to market fluctuations; From the β coefficient, we can also see investors’ expected return on the stock. The higher the β value, the higher the investor’s expected return on the stock. How to calculate Apple's Capital Asset Pricing Model? This chapter will use relevant data from Apple to perform example calculations. Query the current yield of the US 10-year Treasury bond is 2.74%, so Rrf is 2.74% Data source The average return of the S&P 500 is 10%, so, Rm =10% Apple's current coefficient can be obtained from Barron's data, β = 1.22 So, Re = Rrf + β (Rm – Rrf) = 2.74% + 1.22 (10% – 2.74%) = 11.60% Therefore, Apple's current CAPM value is 11.6%. What investment guidance does the capital asset pricing model have?
CAPM is used in the financial industry to calculate a variety of financial indicators, including calculating the weighted average cost of capital (WACC) and calculating the discounted present value of future cash flows (DCF). WACC is a financial value that measures the company's financing costs. When used in WACC, CAPM is used as the equity cost Re to calculate WACC: WACC = (E/V× Re) + (D/V×Rd×(1−Tc)) CAPM will affect the level of the equity cost of stock investment in the formula. The higher the CAPM value, the higher the company's success in raising funds by issuing shares, and thus, the higher the final WACC value. When investors calculate the shareholder's future cash flow discount rate, they need to use CAPM as the discount rate for calculation, which is the value "r" in the cash flow discount calculation formula. When the CAPM value is higher, the DCF value is lower, which means that as the shareholder invests longer, his future income will be reduced to the current value. The formula for the discounted cash model is as follows: DCFn = CF(1+p)1/ (1+r)1 + CF(1+p)2/ (1+r)2 + CF(1+p)3 / (1+r)3 +…+ CF(1+p)n / (1+r)n Among them, CF represents future cash flow (Cash Flow), and p is the growth rate of the company's cash flow. What are the limitations of using the capital asset pricing model? The limitation of the use of CAPM lies in its numerical ambiguity. Its risk-free interest rate and market expected rate of return are average values, so it is difficult to make a more accurate assessment of a specific moment. During actual evaluation, there may be a large difference between the risk-free interest rate and the current actual ten-year bond interest rate, or there may be a large difference between the market's expected return rate and the current S&P 500 return rate, which may cause errors in the evaluation results. The β value also has a certain error range, because the β value is calculated based on historical stock returns, but the volatility of stock prices is usually very high, and it is difficult to find a relatively predictable pattern, so it is difficult to calculate a more accurate and appropriate CAPM value using the β value. Secondly, the CAPM value considers the non-systematic risk value, without taking into account the specific risk value in a specific industry or the individual risk characteristics of a specific company. Therefore, the CAPM value is more suitable for evaluating the impact of market risk on investment, and cannot further consider the impact of a specific object's business model on investment returns.