The capital asset pricing model (CAPM) is a widely-used finance theory that establishes a linear relationship between the required return on an investment and risk. The model is based on the relationship between an asset's beta, the risk-free rate (typically the Treasury bill rate) and the equity risk premium, or the expected return on the market minus the risk-free rate.
At the heart of the model are its underlying assumptions, which many criticize as being unrealistic and might provide the basis for some of the major drawbacks of the model. (For more insight, investigate how to calculate the beta of a private company.)
Like many scientific models, the CAPM has its drawbacks. The primary drawbacks are reflected in the model's inputs and assumptions, including:
- Risk-free rate (Rf): The commonly accepted rate used as the Rf is the yield on short-term government securities. The issue with using this input is that the yield changes daily, creating volatility.
- Return on the market (Rm): The return on the market can be described as the sum of the capital gains and dividends for the market. A problem arises when at any given time, the market return can be negative. As a result, a long-term market return is utilized to smooth the return. Another issue is that these returns are backward-looking and may not be representative of future market returns.
- Ability to borrow at a risk-free rate: CAPM is built on four major assumptions, including one that reflects an unrealistic real-world picture. This assumption, that investors can borrow and lend at a risk-free rate, is unattainable in reality. Individual investors are unable to borrow (or lend) at the same rate as the US government. Therefore, the minimum required return line might actually be less steep (provide a lower return) than the model calculates.
- Determination of project proxy beta: Businesses that use CAPM to assess an investment need to find a beta reflective to the project or investment; often a proxy beta is necessary. However, accurately determining one to properly assess the project is difficult and can affect the reliability of the outcome.
Despite the aforementioned drawbacks, there are numerous advantages to the application of CAPM, including:
- Ease of use: CAPM is a simplistic calculation that can be easily stress-tested to derive a range of possible outcomes to provide confidence around the required rates of return.
- Diversified Portfolio: The assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates unsystematic (specific) risk.
- Systematic Risk (beta): CAPM takes into account systematic risk, which is left out of other return models, such as the dividend discount model (DDM). Systematic or market risk is an important variable because it is unforeseen and often cannot be completely mitigated because it is often not fully expected. (For more insight, read about the difference between systematic and unsystematic risk).
- Business and Financial Risk Variability: When businesses investigate opportunities, if the business mix and financing differ from the current business, then other required return calculations, like the weighted average cost of capital (WACC), cannot be used. However, CAPM can.
The Bottom Line
No model is perfect, but each should have a few characteristics that make it useful and applicable. CAPM, while criticized for its unrealistic assumptions, provides a more useful outcome than either the DDM or WACC in many situations. It is easily calculated and stress-tested, and when used in conjunction with other aspects of an investment mosaic, it can provide unparalleled yield data that can support or eliminate a potential investment.