What are the limitations of using CAPM to calculate cost of equity?

1 Assumptions and data

CAPM relies on several assumptions that may not hold true in reality, such as efficient markets, frictionless trading, homogeneous expectations, and zero taxes. These assumptions simplify the model, but they also ignore some important factors that can influence the cost of equity, such as transaction costs, market imperfections, investor preferences, and tax effects. Moreover, CAPM requires data on the risk-free rate, the market return, and the beta of the asset, which may not be easy to obtain or reliable. The risk-free rate may vary depending on the maturity and currency of the security, the market return may depend on the choice of the market index and the time period, and the beta may change over time or differ across sources.

2 Static and linear

CAPM assumes that the cost of equity is constant and linearly related to the beta of the asset. This means that the model does not account for the dynamic and nonlinear nature of risk and return in financial markets. For example, CAPM does not capture the effects of changing macroeconomic conditions, market cycles, investor sentiment, or asset-specific events on the cost of equity. It also does not reflect the possibility that investors may have different risk preferences or expectations for different levels of risk. Therefore, CAPM may not be able to capture the true risk-return trade-off for an asset or a project.

3 Diversification and market portfolio

CAPM assumes that investors are fully diversified and hold the market portfolio, which is the weighted average of all risky assets in the market. This implies that investors only care about the systematic risk of an asset, which is the risk that cannot be eliminated by diversification, and not the unsystematic risk, which is the risk that is specific to an asset or a project. However, in reality, investors may not be fully diversified or hold the market portfolio, either due to practical constraints, behavioral biases, or other reasons. Therefore, investors may also care about the unsystematic risk of an asset or a project, and demand a higher return for bearing it. In addition, CAPM does not specify what constitutes the market portfolio, which may vary across regions, sectors, or asset classes.

4 Empirical evidence and alternatives

CAPM has been tested empirically by many studies, but the results have been mixed and controversial. Some studies have found support for the model, while others have rejected it or found anomalies that contradict it. For example, some studies have found that low-beta stocks tend to outperform high-beta stocks, or that other factors, such as size, value, momentum, or quality, can explain the cross-sectional variation in stock returns better than beta. Therefore, CAPM may not be able to explain or predict the actual cost of equity for an asset or a project. As a result, some practitioners and academics have proposed or used alternative models, such as the arbitrage pricing theory (APT), the Fama-French three-factor model, or the multifactor models, to estimate the cost of equity.

5 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?