Thursday, December 8, 2022

How to Use Capital Asset Pricing Model to Effectively Invest in Stocks

What is Capital Asset Pricing Model?

A capital asset pricing model (CAPM) is a statistical tool for discounting the future cash flows of a company. These cash flows can be estimated from the cash flows of previous investments. A stock market discounting process uses this model to value a stock. The model was first proposed by George Akerlof and Kenneth Arrow in 1971.

The capital asset pricing model seeks to establish the value of a stock at different interest rate scenarios. While the market is discounting a stock’s price to fair value, the risk-reward equation of the stock is put into perspective by considering both the current interest rate scenario and the interest rate projections for the future. If the company has a competitive advantage over its competitors, its stock price is expected to increase.

How to Calculate the Cost of Capital

Capital Asset Pricing Model, also known as CAPM, is a complex and mathematical framework for modeling the market’s value of a firm’s equity or debt or both.

This system takes into consideration not just company-specific factors but also the broader macroeconomic environment.

In a nutshell, the model provides investors with a very good guide for pricing the stocks that they invest in.

To explain this further, I will be using a simple analogy of a farmer taking up a piece of land on which he can build a house.

The Formula for Capital Asset Pricing Model

The formula was derived from math that uses discounted cash flows, growth rates, and the stock’s correlation to the capital asset pricing model.

Basically, price is used to calculate the amount of an asset’s future cash flows that can be extracted, discounted, and applied to the present.

Capital Asset Pricing Model

The investment case is that if you pay today’s price, you get more future cash flows today. Conversely, if you buy an asset at a discount to future cash flows, you will have to wait longer to harvest the gains.

The Discounted Cash Flow Model

I developed a discounted cash flow model that produces price projections that are based on the weighted average cost of capital (WACC). This WACC is the risk-free rate times the average cost of equity capital.

What are the Capital Asset Pricing Model’s Limitations?

The Capital Asset Pricing Model (CAPM) is a mathematical model for quantifying the risk-adjusted future cash flows of a security. However, like any model, the CAPM model has limitations. This model is used to measure how risky an investment is, based on the return potential of the asset and the risk. Although CAPM is valuable, there are some points that investors must know in order to efficiently use the CAPM in investment decisions.

How to Use the Model

Strategy 1: Buy the S&P 500

This strategy comes in two variations – the first strategy uses a system where the future return for the S&P 500 has a modelled distribution of returns, so that a portfolio having equal amount of S&P 500 at all periods is a representative allocation of the future return distribution.

Strategy 2: Buy the Whole S&P 500

This strategy returns equal dollar amount to the overall dollar amount of investments at every period.

Factors to Consider

Performance data is misleading when looking for investment advice because at any given time, you cannot predict the future performance.

One common practice of fund managers and other investors is to use performance data to select or set asset allocations.

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