What are the advantages and disadvantages of using CAPM to discount cash flow?

1 How CAPM works

CAPM assumes that investors are rational and diversified, and that they demand a higher return for taking more risk. It also assumes that there is a risk-free asset, such as a government bond, that offers a certain return with no risk. CAPM then calculates the expected return of any asset by adding a risk premium to the risk-free rate. The risk premium is based on the asset's sensitivity to the market movements, measured by its beta coefficient. The formula for CAPM is:

Expected return = risk-free rate + beta * (market return - risk-free rate)        

3 Disadvantages of CAPM

However, CAPM also has some limitations and drawbacks. One of them is that it relies on several unrealistic assumptions, such as the existence of a risk-free asset, the perfect efficiency of the market, and the homogeneity of investors' expectations and preferences. These assumptions may not hold true in the real world, where there are taxes, transaction costs, information asymmetries, and behavioral biases that affect the market and the investors. Another drawback of CAPM is that it only considers the systematic risk of an asset, and ignores the unsystematic risk, which is the risk that is specific to an asset or a project. This means that CAPM may not capture the full risk profile of an asset or a project, and may underestimate or overestimate its required return. For example, CAPM may not account for the impact of factors such as competition, regulation, innovation, or reputation on the cash flows of an asset or a project.

4 Alternatives to CAPM

Because of these disadvantages, some analysts and investors prefer to use other methods to discount cash flow, such as the weighted average cost of capital (WACC), the arbitrage pricing theory (APT), or the dividend discount model (DDM). These methods have their own advantages and disadvantages, and may require more data and calculations than CAPM. For example, WACC considers both the cost of equity and the cost of debt of a project or a company, but it may be difficult to estimate the optimal capital structure and the market value of debt. APT accounts for multiple sources of risk, but it may be challenging to identify and measure the relevant risk factors. DDM focuses on the dividends paid by a company, but it may not be applicable to companies that do not pay dividends or have unstable dividend policies.

5 How to choose the best method

There is no definitive answer to which method is the best for discounting cash flow, as it depends on the context, the objective, and the availability of information. Each method has its strengths and weaknesses, and may produce different results for the same asset or project. Therefore, it is important to understand the assumptions and limitations of each method, and to use them with caution and judgment. You may also want to use more than one method to cross-check and validate your estimates, and to perform sensitivity analysis and scenario analysis to account for the uncertainty and variability of the cash flows.

6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?