CAPM

The capital asset pricing model (CAPM) is a method of valuing not just securities, but any investment, using a DCF with a risk adjusted discount rate.

The method used to calculate an appropriate discount rate uses the investment's beta. This is a measure of the amount of risk that the investment would have in the context of a diversified portfolio. Beta is denoted by the Greek letter β. Estimates of the beta of the shares of most listed companies can be obtained from sources such as Bloomberg.

The discount rate used in a CAPM DCF is:

r = rf + ( β × (rm - rf))

where rf is the risk free rate
rm is the expected return on the market and
β is the beta of the cash flows or security being valued.

The term rm - rf is the market risk premium. The term β×(rm - rf) is the risk premium on the cash flows (or security) being valued.

If the securities being valued are shares it is usual to use the equity risk premium and the beta of the share against the stock market. It is possible to use the wider securities market but there is no real reason to do so.

The beta adjusts the discount rate for the correlation between the cash flows being valued and the volatility of the market. This an important measure of risk because this element of risk cannot be diluted by diversification.

The cash flows should the be the expected values of the future cash flows.

The CAPM is the mostly widely used single valuation model as it can easily be applied to the most common types of investment. Other important valuation models include arbitrage pricing theory (which is harder to apply) and Black-Scholes (primarily useful for options).

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