Is the Capital Asset Pricing Model dead ? ( article 3 of 12 )

Joris Kersten (1980) works with "Kersten Corporate Finance" as an independent M&A consultant in The Netherlands.

Moreover, twice a year he provides a 6-day valuation training in The Netherlands, the next one is: 28th September - 4th October 2022 at Amsterdam South (Zuidas).

M&A consulting: www.kerstencf.nl

Valuation training: www.joriskersten.nl

Article 3 of 12: Is the Capital Asset Pricing Model dead ? (CAPM)

Author article: Joris Kersten, MSc BSc RAB

Source blog - Book: The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.

Introduction: Reviewing the Capital Asset Pricing Model (CAPM)

In this blog I will talk about the CAPM and other competing models that are used to calculate the cost of equity.

The main approaches to calculate the cost of equity are:

-Explanatory models: These models use assumptions with statistics from market data to calculate the cost of equity. These models include CAPM, Arbitrage Pricing Theory (APT) and the Fama French Three Factor Model.

-Deductive models: These models deduce the cost of equity from current share prices and discount rates on estimated growth. An example of the deductive approach is the “Dividend Discount Model” (DDM).

Let’s now look at these explanatory and deductive models in more detail.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Explanatory models of the cost of equity

Most cash flows will have an expected variation or volatility. And cash flows vary for two reasons.

First because of generic economic and market risk factors to which every business is exposed. And second, because of specific risk factors that relate to the operating environment of the particular project or company.

As mentioned before, “modern portfolio theory” suggests that the second type of risk, specific risk, can be “diversified away”. So that in efficient capital markets portfolio equity investors are only exposed to market risk.

The explanatory models that will be covered here are all based on the hypothesis that equity investors hold diversified portfolios of equity investments. Therefore they only require returns for market (systematic) risk.

Let’s now take a look at the CAPM, the Arbitrage Pricing Theory (APT) and the Fama French Three Factor model.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Explanatory model 1: Capital asset pricing model (CAPM)

CAPM is used all around the world. And CAMP is a relatively simple method for calculating the cost of equity in order to explain a complex world.

It tries to predict the future returns required by investors through the examination of historic returns. This since usually Beta and the Equity Market Risk Premium (EMRP) are estimated with reference to the past.

A number of studies have been carried out in order to test whether CAPM holds over time. These involve forming portfolios of securities ranked by beta and testing over long periods of time whether actual returns can be explained by the different portfolio betas.

Some work has supported CAPM. While other studies suggested that other factors seem to be useful in explaining the relationship between stock pricing and returns in addition to beta.

These factors are for example: Total capitalization, dividend yield and ratio of book value in relation to market value.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Explanatory model 2: Arbitrage Pricing Theory (APT)

In CAPM the beta is generated by regressing the movement in returns on a specific security against the returns on the market as a whole.

A beta of 1 means that the security is perfectly correlated with the market, and a lower or higher beta means movements are less or more correlated.

Within CAPM all that matters is the level of the beta since the risk free rate and the EMRP are common across all stocks (in the same geography).

So it does not matter what factors have driven the beta to a certain level.

Now APT introduces a range of coefficients and terms which play a similar role in capturing risk to that which beta does for CAPM.

But these terms are for fundamental economic variables which are considered to be important in determining how sensitive a stock is to market risk factors.

Some examples are: interest rates (long-term/ short-term), inflation and business outlook.

Depending on the variables chosen, some studies suggest that these models may give a better explanation of investment returns than CAPM in industries such as banking, oil and utilities.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Explanatory model 3: Fama French Three Factor Model

The Fama French Three factor model is built on the same principle as the CAPM and APT.

But as well as a measure similar to beta, this models adds extra factors like company size and the ratio of book value to market value.

The risk free rate is the same as within CAPM.

I will discuss the use of size adjustment in great detail later in the sequence of blogs on the cost of capital

And the inclusion of the ratio of book to market value implies that the cost of equity rises as a company’s market capitalization falls.

The rationale for this appears to be that equity investors will require a higher return as a firm gets closer to being in state of financial distress.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

The output of explanatory models on the cost of equity

Tim Ogier, John Rugman and Lucinda Spicer are showing in their great book “The Real Cost of Capital” of 2004 (see the source details at the end of this blog) the effects on outputs on taking a certain model (table page 90 of the book).

They show the costs of equity at the beginning of 1999 of major companies in:

Financial services, integrated petroleum and general companies.

The calculations come from US data sources and dollar interest rates are used.

Costs of equity (Average):

General Companies (e.g. Coca Cola, General Motors Group, McDonald’s Corp, Proctor & Gamble, Walt Disney Company):

-CAPM: 10.50 %

-APT: 12.15 %

-Fama French: 9.53 %

Integrated petroleum companies (e.g. Chevron Corp, Exxon, Texaco):

-CAPM: 8.07 %

-APT: 10.81 %

-Fama French: 10.12 %

Financial Services companies (e.g. Citigroup, Morgan Stanley Dean, Wells Fargo):

-CAPM: 12.94 %

-APT: 14.93 %

-Fama French: 18.47 %

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Deductive models of the cost of equity

Deductive models seek from market available information what the cost of equity is.

An example is the “dividend discount model” (DDM).

This model takes the cost of equity from the current share price, combined with forecasts of future movements in dividends and growth estimates of a company or market.

In its simplest form the DDM uses a constantly growing cash flow in perpetuity. And a more sophisticated approach uses a formula which divides growth of dividend flows into various stages.

The advantage of this approach is that in the real world, forecasts of investment returns and growth expectations can be used to build up a forward looking picture of the cost of equity.

This does not mean we can forget for example CAPM, because the downside of this deductive approach is that forecasting of dividends and growth is very difficult.

Having said all this, CAPM is still very much used all over the world. Also more than APT and Fama French, probably because these methods are more complex to understand.

And because so many business decisions are made on CAPM, I do not dare to say CAPM is dead, although its shortcomings.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Source blog - Book: The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.

Thanks for reading, hope to see you next week again, then the article will be about the "the cost of debt" (WACC).

Best regards, Joris