1. Understanding the CAPM
So let's look at the capital asset pricing model, the framework we're calculating
the cost of equity based on return and volatility.
We've drawn a line that starts at the risk free rate,
the risk free rate has a positive return, as you can see on
the vertical axis, and on the horizontal axis, it intersects the vertical,
so it has no risk. So what you'll see here is that the
risk free rate, the point at which it touches the vertical axis,
is its positive return with a risk of zero.
We can then look beyond that and draw a line at the level
of risk where the market is. The stock market has a beta of
one, in other words, if a company has a beta of one,
then it has the same risk as the market,
it will move in the exact direction of the market.
If a company has a beta of 1.25, then it is riskier than
the market, if the market goes up 1%, then the stock will go
up 1.25%. Conversely, if the market goes down 1%, then the stock goes
down 1.25%. And as you can see, this upward sloping line indicates that
as return increases, so does risk. And then we can measure the equity risk
premium, which is the additional amount required by investors for the risk
that they're taking. It's typically between 4% and 8%,
but it can vary over time. So let's look at some specific data
points as examples. As we mentioned, starting at this point,
we have no risk and a small positive rate of return,
that's at the risk free rate. Then as we stay on the line
and we increase our risk the level of the market, we now earn
a higher rate of return, and that incremental rate of return as measured
on the vertical axis, again typically between 4% and 8%.
You could think of further along the line to this data point,
where we have what might be a beta of two, so twice as
volatile as the market. And then we can see the corresponding rate of
return on the vertical axis, just higher than the rate of return
for a stock with the same beta as the market,
which was that middle data point. Now, let's go off the line a
little bit and explore what happens elsewhere on this graph.
The top data point, a company has a more attractive return versus risk
profile than others, because it's above the line,
meaning it gets a higher rate of return but with less volatility than
is expected by the capital asset pricing model.
Conversely, data point below the line is the opposite,
it's experiencing more risk, more volatility of return but producing less
overall return than would be expected by investors.
So it's important to think about how you can achieve high rates of
return with lower risk where possible, and what that means for the pricing
of assets.
2. Let's practice!