capm the great

Capital allocation..an investing decision 

In corporate finance, a manager will have to find out the hurdle rate that reflects the riskiness of assets and cash flows which will satisfy the capital providers. Put another way, the investors (both debt and equity) will have to ensure that they earn at least that rate. This makes sense.  

The rate of return

But how do we calculate this rate? As investors, you could simply state it intuitively, or expect a rate of return that is both reasonable and feasible based on your analysis, or build models to calculate it. The first two methods are less popular, not traditional and pose a problem to the manager who has to select one rate. They are also not precise. Therefore, the third method is widely accepted.

The models, once key inputs are known, throw out the hurdle rates with precision. So far the story looks good and interesting. Let's continue.

The capm

One of the most popular models on measuring risk and return in corporate finance is the capital asset pricing model, or just, the capm. The model itself is simple to calculate the rate of return; however, it uses several assumptions in the process. It measures the expected return using just three inputs: the risk-free rate, the beta and the risk premium. You input these three, and out comes the rate you want. Aha! The managers understand the cost of their capital, and the investors get to know their minimum expected rate of return; everyone is happy; supposedly.

The capm problem

This cost of capital measure comes with a cost, though. It is interesting to note that a majority relies on the capm, some notwithstanding its limitations and some not understanding its limitations.

Survival of the strongest

The model starts with the notion that managers will have to satisfy only the marginal investors who own significant stock and trade that stock to set the stock prices. While it appears to be valid, it can also mean both the managers and marginal investors are taking other investors for a ride. Every investor will have some expectation regarding the rate of return, why disregard that?

The risk and reward

Then the model argues that risk is to be rewarded. This one too looks fine; but then there is another argument that why take risk at all no matter how much the reward is. Isn't less risk good for the investors?

This brings us down to the definition of risk. From investment point of view, risk has to mean potential downside to the capital invested. The capm probably accepts this definition, but puts it differently, and says any likelihood of deviation of the actual returns from the expected return is risk. That's cool too.

Market-wide diversification

The capm then assumes that only market risk which is not diversifiable has to be rewarded; that is, any risk that is firm-specific can be diversified away by either the managers or the marginal investors and therefore is not to be rewarded. In effect, the model argues that the investors cannot find mispriced securities in the market and therefore encourages diversification.

The capm tells the investors to hold the market portfolio, i.e. buy every asset that is traded in the market, both local and international; the investment in each asset is assumed to be in proportion to its market value. In practice, however, it is not followed. Conveniently, the local index (of stocks only), such as S&P-500 and NSE-50, is considered as the market. This is circumventing the capm itself.

This also goes against the pursuit of many investors who consider that the market, on many occasions, is not efficient. These investors, therefore, believe that they can select mispriced securities with little diversification and maximize returns.

Measuring risk...the beta way

More controversial is the way the capm measures risk. It equates volatility of stock prices to risk of investment, and says that this volatility can be measured by the beta of that stock. This means if the stock prices move up or down significantly when compared to the market (index) movement itself, the stock is considered risky, will have higher beta, and therefore needs to be rewarded with higher rate of return.

There are investors, however, who argue that volatility (or the beta) has nothing to do with risk, which is actually measured somewhat less precisely. For instance, although a stock, due to mispricing, may have gone down significantly, its intrinsic value may remain intact. Since its fundamental value drivers (cash flows, growth, or business risk) have not changed the price should come back to reflect its true value sooner or later. Where is the risk here? The stock prices may be volatile, the beta may be high, but the stock may not be risky. Conversely, a stock having stable-looking prices may actually be a risky business and may go down over time due to deteriorating fundamentals. In effect, if we accept that stocks can often be mispriced in the market, the measure of volatility (the beta) as risk need not be accepted.

Wishful thinking

The capm also assumes that there are no transaction costs related to buying and selling. This does not hold good in any market. Frequent buy and sell decisions could affect return significantly in the long term.

The precision in appearance

Finally, with all the inputs in place, the capm throws out the discount rate with such precision in appearance that corporate finance has embraced it without much fuss. However, given the inputs and underlying assumptions, it is not certain that the model will be able to estimate the rate that is actually precise. Needless to say, incorrect precision leads to incorrect investment decisions.

The alternatives

Given the limitations of the model to measure the expected rate of return, we could look for an alternative method; this takes us to the purchasing power theory, inflation, market return and analysis of business; reasonable and practical, but a little imprecise.

The game never stops

All said, whether you like the capm or not, the game is on...