09) Financial Concepts: Capital Asset Pricing Model (CAPM)

Capital Asset Pricing Model was developed originally by Harry Markowitz in 1952. It was modified a decade later by others. The CAPM is the relationship between change and expected return and serves as the model for the pricing of risky securities. CAPM states that the expected return of a security or portfolio equals the rate on a risk-free security and a risk premium. If the expected return is not met or beaten by the required return, then the investment should not be attempted. We use the following formula to describe the CAMP relationship:

Required/Expected Return = RF Rate + (Market Return – RF Rate) x Beta

Let’s take Company X as an example. The current risk free-rate is 5% and the S&P 500 is expected to return to 12% next year. We want to know the return Company X will have next year. We have determined a beta value of 1.9 for Company X, while the overall stock market has a beta of 1.0. The beta of 1.9 tells us that it carries more risk than the overall market. The extra risk signifies that we should expect higher potential return than the S&P 500’s 12%. This is calculated as follows:

Required/Expected Return = 5% + (12% – 5%) x 1.9 = 18.3%

This tells us that Company X has a required rate of return of 18.3%. Therefore, if you invest in Company X, you will get about 18.3% return of investment. However, if you think it will not produce those kinds of returns, then you might want to invest your money in a different company. Note that high beta shares are also the worst performers during bear markets over a long period of time. There is also no guarantee that the CAPM return is realized even while you receive high returns from high beta shares.