3.2.3. Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model is an alternative to calculate the cost of equity of an asset and one of the most widely used. It is based on information that is available in the financial markets, but, unlike the dividend-discount models (which require the share price) it can be used to calculate the cost of equity of non-listed companies and it is in fact common practice to do so.

CASFLO APP feasibility analysis uses the CAPM to calculate the cost of equity.

Note: there is plenty of information and academic research about the CAPM model, how it is derived, its faults or critics and variations. Our goal is only to explain how the model works. It is not our objective to present an extensive analysis of the model.

The CAPM states that the investors’ expected return is the sum between the return of a risk-free asset and the risk premium of a specific asset. The specific risk premium is itself a function of the market’s risk premium and of the asset’s systemic risk factor.

  • \(r_e=r_f+\beta(r_m-r_f)\)

Where:

  • rf: rate of return risk-free asset.
  • β: systemic risk coefficient of the company vis-à-vis the market.
  • rm: expected return of the market.
  • (rm – rf): expected risk premium in the market.

The graphic representations is the security market line (SML). On the horizontal axis you travel along the systemic risk coefficient of a particular asset. On the vertical axis you travel along the expected return by investors. The slope of the SML is given the systemic risk coefficient.

Since the systemic risk coefficient of an asset always its comparative to the market, then the β  of the market is 1.

As you may have noticed, to use the CAPM you need to know:

  • rf: rate of return risk-free asset.
  • β: systemic risk coefficient of the company vis-à-vis the market.
  • rm: expected return of the market.

Of these three elements, two can be obtained with public information: the rf and rm and, more importantly, they do not depend on information about the company, its equity or any data that is related to one single company: it is all about market information.

The β, the element that is specific to the company, is the one that can be trickier to identify (or to correctly assume). For listed companies there is data available, whereas for non-listed companies this kind of information does not exist. The common practice is to assume the components of the CAPM model by using proxies. As such some precautions must be taken in assuming the CAPM variables when determining the cost of equity capital of a non-listed company.

Variations

There are several variants at the CAPM, such as the introduction of a specific risk factor.

Where:

  • α: specific risk factor.

The specific risk premium of the company might arise from a wide range of factors:

  • Size of enterprise: smaller companies have greater uncertainty;
  • Restricted access to financing instruments (an aspect which is also related to the size of the company).
  • Small customer base: If your company has a small customer base, your dependence on such clients will rise and may result in less trade negotiation capacity and a high risk of exit of a client;
  • Geographical location: the location where the company develops the business may affect how this is perceived by investors, particularly if you are dependent on the evolution of economic activity at that location.
  • Dependence on key individuals: If there is a high dependency on one individual or reduced number of individuals, regarding technic knowledge, commercial capacity, management or other, a company’s risk will be higher, particularly if it is perceived that those individuals may leave the company in the short to medium term, or for instance if the management is centralized on an individual with advanced age.
  • Limited range of products or services: a small number of products or services may be a sign that the company is quite dependent on the evolution of the market segments in which it operates. If for the sake of technology, the products and services it sells become obsolete, the company may face serious difficulties. That limitation of goods or services is not always a problem: utilities companies (water, sanitation, energy, etc.), though having small set of services, are business that can be quite stable.
  • Litigation or regulatory risks: companies may be subject to legal action filed against them in a way that obstructs its business. Uber is an example of such cases; the company has faced several legal challenges in many countries which may affect the way the company runs its business.

There are other variations of the CAPM model, such as the one developed by Eugene Fama and Keneth Fench, which propose the inclusion of variables according to the size of the company and the Price-to-book ratio.

Being practical

We went through part of the CAPM construction and alternative models. However, for non-academic users who need to use the CAPM for company and project valuation purposes, using CAPM should be immediate and simple and not so much about the academic matters around the CAPM. That means assessing relevant information that allows estimate the beta and the market risk premium.

Fortunately, there is public data that can help you understand how to better parameterize the CAPM. One of the repositories of public information available is the data published by Aswath Damodaran on his site is quite helpful: pages.stern.nyu.edu/~adamodar.

Next Section: 3.2.4. Risk-free asset