One of the models that can be used to project the expected return from a common stock, or any type of asset, is the capital asset pricing model or CAPM. In general, the capital asset pricing model describes the relationship between the risk of a particular asset or stock, its market price, and the expected return to the investor.
The Capital Asset Pricing Model
CAPM states the price of a stock is tied to two variables: the time value of money, and the risk of the stock itself. When we look at some of the formulas used in the CAPM later, we'll see that the time value of money is represented by the risk-free rate of interest or rf.
When measuring the risk of the stock itself, the capital asset pricing model explains that risk in terms that are relative to the overall stock market risk. Fortunately, this is exactly what a stock's beta measures. To figure out the expected rate of return of a particular stock, the CAPM formula only requires three variables:
rf = which is equal to the risk-free rate of an investment
rm = which is equal to the overall stock market risk
B = which is equal to the stock's beta
Using CAPM to Calculate Stock Returns
We've already discussed in our article, Calculating Stock Prices, how the price of a common stock is equal to the discounted value of the expected dividend stream and the end-of-period stock price. The CAPM helps investors to figure out the expected return on a particular investment.
CAPM Formula
The calculation provided by the CAPM helps investors determine their return by using a formula that explains the relationship between expected return and risk: Expected Rate of Return = r = rf + B (rm - rf) Where:
rf = The risk-free interest rate is what an investor would expect to receive from a risk-free investment. Typically, U.S. Treasury Bills are used when examining U.S. dollars, and German Government bills are used for the Euro.
B = A stock beta is used to mathematically describe the relationship between the movements of an individual stock versus the entire market. Investors can then use a stock's beta to measure the risk of a security.
rm = The expected market return is the return the investor would expect to receive from a broad stock market indicator such as the S&P 500 Index. For example, over the last 17 years or so, the S&P 500 has yielded investors an average annual return of around 8.10%.
So what exactly does the CAPM formula tell us? The formula states the expected return of a stock is equal to the risk-free rate of interest, plus the risk associated with all common stocks (market premium risk), adjusted for the risk of the common stock being examined. In other words, the investor can expect a rate of return on an asset that compensates them for both the risk-free rate of interest, the stock market's risk, and the stock's individual risk.
Calculating Expected Returns
Individuals interested in running through calculations using the CAPM approach, can use our Capital Asset Pricing Model Calculator. That calculator provides guidance on finding a stock's beta online, information on the risk-free rate of interest, as well as the expected market return.
The CAPM formula tells us investors can expect a rate of return that compensates them for the risk-free rate of interest, the stock market's risk, and a stock's individual risk.Moneyzine Editor
By using the above-mentioned information, the calculator can figure out the expected stock market premium, in addition to the expected rate of return for a capital asset (a share of common stock in this example).
CAPM versus Arbitrage Pricing Theory
With the advent of modern computers, and the complex relationships they can examine, it is surprising there hasn't been more interest in the Arbitrage Pricing Theory or APT. The approach was first outlined by Stephen Ross in his publication The Arbitrage Theory of Capital Asset Pricing, which appeared in the Journal of Economics in December 1976. While the CAPM builds on the concept of investors constructing efficient portfolios, the arbitrage pricing theory attempts to explain the expected return on a stock in terms of other factors. APT differs from CAPM in that it assumes that a stock's return depends on multiple factors, as explained by the APT formula below: Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)... + bn x (factor n) Where:
b = the sensitivity of the stock to each factor
factor = the risk premium associated with each variable
The APT is different than CAPM in that it doesn't attempt to identify each of the factors for a given stock. For example, the price of oil might be one factor that applies to ExxonMobil but not to Colgate Palmolive. While the entire APT approach provides a great deal of analytical "leeway," it is this same lack of specificity that makes the CAPM approach easier to understand and calculate.
Additional Resources
- This is the first in a four-part series of articles that will cover the topic of stock research. In this article, we're going to discuss the fundamentals of investing, how to find excellent stocks, and the types of companies to avoid.Moneyzine EditorSeptember 21st, 2023
- Generally, investors buy common stocks for two reasons: they offer a cash dividend, and they also have the potential to provide a capital gain. In this article, we will present a method for calculating stock prices based on a constant growth model, leveraging a discounted cash flows approach which considers both dividends and capital gains.Moneyzine EditorOctober 17th, 2023
As its name implies, the Arbitrage Pricing Theory, or APT, describes a mechanism used by investors to identify an asset, such as a share of common stock, which is incorrectly priced. Investors can subsequently bring the price of the security back into alignment with its actual value.Moneyzine EditorJanuary 5th, 2024- Perhaps the single most important measure of stock risk or volatility is a stock's beta. It's one of those at-a-glance measures that can provide serious stock analysts with insights into the movements of a particular stock relative to the overall market. In this article, we're going to first attempt to define the concept of beta values, including some of the theory upon which it's based. Next, we're going to talk about the pros and cons of the measure, while providing insights into the correct use of beta values when analyzing a stock. Finally, we're going to finish up with...Moneyzine EditorSeptember 21st, 2023
- One of the most respected names in the investment community is Value Line. Their research is an outstanding resource to both new and seasoned investors. While a subscription might seem expensive, publications are often available for free at local libraries.Moneyzine EditorSeptember 21st, 2023
- Today's stock market is more than just a place to buy and hold securities. Many investors prefer to move quickly in and out of the market. That's just one reason technical strategies, such as price momentum, have grown in popularity.Moneyzine EditorSeptember 21st, 2023
- Economists, scholars, and market analysts have been searching for ways to predict the movement of individual stocks for many years. Chartists and technical theorists believe historical patterns can be used to project future prices. While the random walk hypothesis claims that such movements cannot be accurately predicted. In this article, we're going to explain the principles behind the random walk theory. As part of that discussion, we'll start by comparing random walk to other popular theories such as the efficient market hypothesis, fundamental analysis, and technical analysis. Next, we'll talk about the modern history of this theory. Then we'll...Moneyzine EditorSeptember 21st, 2023
