NOTES FOR THE REVIEW OF THE CAPITAL ASSET PRICING MODEL

The purpose of this note is to review the development and use of the “capital asset
pricing model” – hereafter referred to as the CAPM.
An informationally efficient stock market is defined as one where all currently-
available, public information is immediately and unbiasedly reflected in, or discount-
ted in, stock prices, such that there is no undiscounted information in the market.
“Immediately” means within a few seconds, if not faster. “Unbiased” price reactions
means – not that the instantaneous post-news-receipt prices changes will always be in
the direction and magnitude that eventually proves to be the correct one, but rather –
it is equally likely that the post-news-receipt price reaction will be an overshoot of the
eventual warranted equilibrium change as an undershoot of this eventual reaction.
A perfectly competitive stock market is defined as one where (a) all investors have
the same opportunities to invest (e.g., there are no institutional constraints on the
purchase of securities and all investors face equivalent information and transaction
costs) and (b) there is no stock price manipulation because all investors are price-
takers and no person or coordinated group can “corner the market” in any stock.
When attempting to value stocks which are traded actively on perfectly-competitive,
informationally-efficient markets and all other assumptions behind the CAPM’s deri-
vation hold approximately true, then the CAPM may be an appropriate model to use,
and it will certainly be the simplest model to use, to estimate the equilibrium market
value (MV) of a firm’s shares. The factors to consider when assessing the appropri-
ateness of relying on the CAPM are discussed in detail on the final page of this note.
Because the assumptions and conditions supporting the use of the CAPM often don’t
hold sufficiently true in real world situations, the relevance and usefulness of the
CAPM is an empirical question, to be examined by students on a market-by-
market, or firm-by-firm, or case-study-by-case-study basis.
Conceptual Rationale behind the CAPM’s Development
In finance, we assume that most investors are “risk adverse” – i.e., all other things
being equal – such as two securities offering the same expected return [E(r)] – they
prefer less risk to more risk. (If they were indifferent to risk, they would be “risk
neutral”.) Where P stands for price and DPS for dividend per share, the formulas for
calculating a security’s actual/experienced rate of return (r) and E(r) are:
r = [P1 – P0] + DPS E(r) = [E(P1) – P0] + E(DPS)
P0 P0
Generally, the standard deviation of investment returns [SD(r)] is used to measure the
total I risk for individual stocks and portfolios. One of the best ways for investors to
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reduce their investment (I) risks is to diversify their I portfolios across a large number
of securities (i.e., not “put all their eggs in one basket”). This diversification process
makes the per-unit total riskiness of their portfolios, SD(rP), much, much less than the
weighted-average riskiness of their constituent securities
SD(rp) < < ∑i wi ∙ SD(ri),
where wi is the proportion of the MV of the portfolio made up by security i. The
explanation for this phenomenon begins with a recognition that total I risk is com-
posed of two parts, namely systematic risk and unsystematic risk.
The systematic risk of a stock is defined as that portion of the uncertainty about a
stock’s future return – i.e., that portion of its total variability risk or of its anticipated
standard deviation of investment return, or SD(ri ) – that is linked to, or attributable
to, the uncertainty about those “common factors” which influence the prices and
returns on all securities. These common factors include interest rates, inflation, the
growth rate in GDP, monetary and fiscal policies, investor psychology, and, in
Canada, the $Cdn/$US exchange rate. Because systematic risk is linked to these
common factors, investors cannot avoid or nullify it by switching from one stock to
another, or by buying a combination of stocks.
Unsystematic risk (the complement of systematic risk) is defined as that portion of
the total variability risk of owning a particular stock that is attributable to factors
specific or unique to the particular firm or particular industry – such as industry-
specific tariffs, import quotas, taxes, regulations, and instances of labour unrest.
Because these firm-specific or industry-specific risks are, at least partially, indepen-
dent of each other, their overall impact on the riskiness of a portfolio of stocks can
largely be avoided by judicial diversification of the stocks within the portfolio. This
results from the fact that the effects of these unsystematic risks will often cancel each
other out, as some risks “come home to roost” during the investment holding period
while others are not realized. Consequently, when portfolio mgrs add stocks to an
already-well-diversified portfolio, only the systematic risks embodied in each added
stock are absorbed into, and accumulated in, the portfolio, while their unsystematic
risk elements tend to cancel one another out and to fade in significance as the port-
folio gets larger and more diversified.
Portfolio mgrs realize this and recognize that all they and their clients need to be
compensated for – in terms of some additional E(r) – is the incremental systematic
risk introduced with each added stock. While they may seek incremental returns
above this amount, competition within the stock market will ensure that stock prices
are bid up to the levels where the subsequent E(r)s compensate only for the system-
atic risks embedded in each stock. Hence, the unsystematic portion of a stock’s risk
does not matter (because it is diversified away) and mgrs will focus solely on each
stock’s systematic risk.
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Given the central role that systematic risk plays in portfolio mgrs’ evaluation of the
attractiveness of particular stock’s, we need a way to measure systematic risk analyt-
ically and numerically. The systematic risk that stock i has exhibited historically is
proxied by its historical beta coefficient – ßih. Beta is found by regressing the time
series of a stock’s historical I returns (on the y-axis since it is the dependent variable)
against the returns for the index of the market where the stock is traded (on the x-axis
since it is the independent variable) to construct the characteristic line for the stock
– as shown in the diagram below. Analytically, ß is defined as the value of the slope
coefficient of the stock’s characteristic line regression. Each of the dots in the graph
below represents the (ri, rM) pair for one of the daily, monthly, or quarterly periods in
the time series used to estimate beta (where rM is the return for the market index).

More generally, beta measures the period-to-period volatility of a particular stock’s

return relative to the return for the typical stock (as proxied by the market index). By
definition, then, ß = 1.0 for the average stock; a stock with a ß = 2.0 has periodic I
returns that are twice as variable as the average stock.
Mathematically, ßi = Cov(ri,rM) = SD(ri)·SD(rM)·ρ(ri,rM)
V(rM) V(rM)
If the underlying risk characteristics of a firm do not change substantially over time,
then the ß estimated from historical data may be a reasonable proxy for the future
systematic riskiness of the stock. If not, starting from the historical ß, one must adjust
away from the historical ß to get a better estimate of the stock’s future ß/systematic
riskiness, since it is the future ß that is relevant for stock valuation purposes.
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There are two such adjustments discussed in the course reading “The CAPM
Approach to Estimating the Cost of Equity Capital”. If an aggressor firm merges with
a target firm, the resulting systematic/ß riskiness of the resulting firm will likely
change because its asset mix has been altered as result of the merger. Suppose Firms
A and B merge via an all-share-exchange transaction, the ßAB of the merged firm is
likely to be close to

__SA__ __SB__ where * denotes

ßAB = SA + SB ßA* + SA + SB ßB* pre-merger values

If a firm’s financial leverage ratio has changed over time, then the likely effect of this
change on the overall systematic riskiness of the firm can be approximated using the
formula below, where ßL is the firm’s levered beta and ßU is its unlevered beta, or the
beta risk it would otherwise exhibit if there were no debt on it balance sheet. In the
formula, B is the MV of the firm’s debt, S is the MV of its equity capitalization, and
B/S is its debt-to-equity ratio on a MV basis.
ßL = ßU [1 + (1 – τ)∙B/S] where B/S is on a MV basis
How to use the above formula to estimate how a firm’s ß will change as its target
financial leverage ratio changes is illustrated on page 10 of “The CAPM Approach to
Estimating the Cost of Equity Capital”.
As discussed at the bottom of page 2, portfolio mgrs realize that only the systematic/ß
risks embodied in each added stock are accumulated in their portfolios as they expand
their holdings. As a result, the E(r) they require to motivate each additional stock
purchase is related to the amount of ß risk each new stock adds to their portfolio’s
overall risk. When we aggregate this relationship across all stocks in the market and
solve for the market equilibrium conditions (as John Lintner and William Sharpe did
in late 1964), we find that an investor’s required compensation for taking on system-
atic risk is directly and proportionally related to each security’s systematic risk, as
shown in the word formula below. [“Solving for market equilibrium conditions”
means that security prices and, hence, prospective security returns must all adjust so
that each and every issued and outstanding share of stock is held in some combination
of investor portfolios once equilibrium is reached.]
Recognizing that investors can earn the riskfree rate of return (rF) without assuming
any risk, the notion of “compensation” was seen as an E(r) that exceeded rF. There-
fore, where λ denotes a “constant of proportionality”, the keystone revelation of the
CAPM was that
the reward for assuming the index of
systematic risk in = λ · systematic risk
security i in security i
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In this relationship, λ = the “market price of systematic risk reduction”, or
λ = the per-unit reward for taking on systematic risk, and
λ = [E(rM) – rF] = the “market risk premium”, or MRP, if ß is the
measure used to express systematic risk, and λ is the same for
all stocks.
Replacing words in the above relationship with symbolic expressions, we get
[E(ri) – rF] = λ· ßi = [E(rM) – rF] ßi = ßi ·MRP
Transposing rF from the left-hand side to the right-hand side of the equation, we get
E(ri) = rF + ßi ·MRP, which is called the “security market line” relationship.

Moreover, the SML says that, in equilibrium, in perfectly efficient markets, the
appropriate risk measure to use when estimating the MV of a firm’s shares is ß, not
the stock’s total variability riskiness as proxied by its SD(ri).

As CAPM is a “pricing model”, the final step is to go from E(ri) to a PSi estimate.
By definition (from page 1), E(ri) = [E(Pi) – Po] + E(DPS) (1)
Po
Now, in perfectly-efficient markets, if a firm’s riskiness is not changing, share prices
should increase on average, period to period, by the amount of the firm’s real econ-
omic retained earnings per share (i.e., real RE/sh), because these real RE/sh are
assumed to be re-invested in the firm – to achieve “real” growth, which shareholders
will value – at the firm’s market-determined required rate of return (i.e., at its k e =
E(r) ), because the firm is assumed to be a “normal firm” for purposes of the CAPM.
i.e., a dollar’s worth of real REs is assumed to generate a dollar’s worth of capital
gains in the firm’s Ps, or, in symbols...
real RE/sh = [E(Pi) – Po] = E(capital gain per share).
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Therefore, substituting the above equality into (1), we get...

E(r) = E(real RE/sh) + E(DPS) → E(real economic EPS) (2)

Po Po

Transposing (2), we get the equilibrium CAPM pricing relationship

Poi = CNRE E(EPS) ← this is the CAPM. (3)

E(ri)

Dividing both sides of (3) by E(EPS), we get

Poi = P/E ratio for stock i = 1 = f(βi alone)

E(EPS) E(ri)

i.e., β risk is the only type of risk that is embodied in share prices in a CAPM world.
Hence, if you have empirical evidence that factors other than βi and geEPSi explain P/E
ratios in a particular industry, CAPM may not be the appropriate valuation model to
use.

REQUIRED INFORMATION INPUTS INTO CAPM-SML MODEL:

(1) cyclically-normalized, real economic EPS for the subject firm;

(2) a future-oriented estimate of the firm’s β riskiness;
(3) future-oriented estimates of the “market parameters” rF and the MRP for the
expected holding period involved (see p.4-5 of instructor’s note “The CAPM
Approach to Estimating the Cost of Equity Capital”).

TWO EQUALLY VALID STRUCTURAL FORMS FOR THE CAPM

In both cases, E(ri) = rF + ßi ·MRP = ke = the cost of equity capital for firms.

(a) If the firm pays out all of its real economic EPS each year, then we would expect
a level/horizontal trend in EPS in perpetuity…by definition.
– the present value of this EPS stream to shareholders, as depicted in (a) below, is

Poi = CNRE E(EPS) = CNRE E(EPS) (just like the formula for
E(ri) ke pricing a perpetual bond)
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(b) If the firm pays out DPS which are less than its CNRE(EPS), then, by definition,
we would expect its earning power and dividend-paying power to grow over time,
at some growth rate gDPS.

– the present value of this income stream to shareholders, as depicted in (b) below,
is
Poi = E(DPS) (i.e., the Gordon DCF model
(ke – gDPS) structure)

Properly applied in the same situation, the two formulas should lead to the same P S
estimate; the choice of the model structure to use depends on the ease and reliability
of forecasting gDPS in perpetuity versus estimating the current CNRE E(EPS); also the
analyst will find that small errors in the gDPS estimate will lead to large errors in the PS
estimate.

WHEN IS CAPM VALID FOR ESTIMATING INDIVIDUAL STOCK PRICES

Generally speaking, the CAPM will be a valid and possibly reliable model for
estimating individual equilibrium stock prices when the market within which the
stock is trading is both “informationally efficient” and “perfectly competitive” (see
page 1), and all the underlying assumptions of the CAPM hold at least approximately
true.

Of course, the shares of large, publicly-traded corporations with large daily trading
volumes are more likely to be followed by a large contingent of security analysts and,
thus, be more “efficiently priced” than the shares of smaller firms that attract very
little investor interest, or the shares of non-public companies for which key financial
data is not publicly available.
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From a practical-application perspective, the most important underlying CAPM
assumption is that all the investors in the market where the stock is being traded and
“valued” hold well-diversified security portfolios, such that the individual stock’s
systematic/beta risk is the only risk that investors need to be compensated for.

Another important CAPM assumption is that the firm whose stock we are trying to
“value” is a “normal firm” – i.e., a firm that expects to earn on its future investments
an average rate of return (re) that equals the “cost of equity capital” (ke) or required
rate of return on these investments given their level of risk. The CAPM can, however,
be judgmentally adapted for use in valuing “growth firms” (ones where re > ke); this
will be shown later in the course.

Another assumption is that the firm’s earnings are expected to continue in perpetu-
ity. Of course, if the firm’s earnings and cash flows have a limited life, we may still
be able to use the CAPM to estimate the beta-risk-based discount rate to “value” the
firm’s earnings/cash flows in the context of some time-limited, discounted cash flow
(DCF) model – but this is not the full CAPM.
So, in summary, if the situation is one where:
– the market is “informationally efficient” and “perfectly competitive” (e.g., NYSE);
– the firm is large, publicly-traded, and followed by a large no. of security analysts;
– the firm is a considered to be a “normal firm”;
– the firm and its earnings are expected to continue in perpetuity;
– only beta and geEPS have a significant impact on firm’s P/E ratio (see page 6); and
– those attaching a value to the stock all hold well-diversified stock portfolios,
then the CAPM is a valid model to use to estimate the stock’s equilibrium or fair
price, although the CAPM-derived price may still deviate widely from the observed
market/trading price.

WHAT TO DO WHEN SOME OR ALL OF THE PLAYERS WHO ARE

VALUING A STOCK DO NOT HOLD WIDELY DIVERSIFIED SECURITY
PORTFOLIOS?
In this situation, we need to avail ourselves of valuation models/procedures that are
not reliant on beta risk but, rather, are capable of incorporating measures of total
variability risk and bankruptcy risk in their formulations – namely, the Gordon,
FSASVM, and various DCF valuation models.