What is CAPM and how it is used in investing?

What is CAPM and how it is used in investing?

The CAPM is a practical application of the risk-reward relationship that makes use of beta. It stands for Capital Asset Pricing Model and it is used as a way to price common stocks. In this context, the term “price” is referring to calculating the expected return for a given stock. Because we cannot know what realized returns will be for a security prior to investing in them, expected returns are our proxy for what we expect returns will be given current data. The formula for the CAPM is as follows:

Expected Return = Risk Free Rate + Beta*Market Risk Premium

The market risk premium can be thought of as the additional expected return an investor receives by exposing themselves to the systematic risk of the market. It can be thought of as the expected return on the market (e.g., the S&P 500) minus the risk free rate. This market risk premium is usually somewhere in the 6-9% range, but can vary depending on market conditions, and it is also subject to debate.

We can see that this formula utilizes beta by ensuring that stocks with higher betas (i.e., more risky stocks) are assigned an expected return since beta is multiplied by the market risk premium.

The way you would use this formula in real investing is as the cost of equity for a company. Recall from before that companies can finance their operations either through the use of equity (selling common shares, preferred stock, or using cash flow from operations) or through debt. These two methods of funding operations are unique and have different costs and benefits associated with them. The cost of equity can be calculated using the CAPM, and the cost of debt can be found by determining the current yield-to-maturity on a company’s debt. When we combine these, we get the weighted average cost of capital (“WACC”). Here is the formula:

WACC = Cost of Equity*(Value of Equity/(Value of Equity+Value of Debt)) + Cost of Debt*(Value of Debt/(Value of Equity+Value of Debt))

We can then use our calculated WACC as the discount rate for discounted the future cash flows earned by a business. Because this discount rate takes into account the riskiness of the asset by assigning a higher discount rate to more risky companies, it ensures we as investors are adequately compensating ourselves for the risk we take on when we invest. Cash flows earned by a small-cap biotech stock are much riskier than cash flows earned by a railroad company that has been in business for 150 years. And because money received today is worth more than money received in the future, and investors expect to be fairly compensated for taking on risk when investing, a company’s future cash flows must be discounted at a discount rate.

Thinking about this practically may help you to understand it better. Let’s say there is a company that is entirely funded by $100M worth of debt. The debt has an interest rate of 5% attached to it and the interest rate also happens to be the yield-to-maturity (YTM), and the company has a tax rate of 25%. Because this company has no equity, their cost of debt and WACC is 5%*(1-25%) = 3.75%. Due to the fact that interest payments are tax deductible, the cost of debt is lowered by the tax rate because the company saves on tax by paying interest which lowers their taxable income.

Let’s now say the company then decides to raise $100M in equity through selling common stock. The risk free rate is 3%, the market risk premium is 8%, and the company’s beta is 0.8. WACC would be calculated as follows:

WACC = 5%*(100/200)+(3%+0.8*8%)*(100/200)

WACC = 7.2%

Capital Allocation

Let’s now tie this knowledge of risk, reward, and the cost of capital into the concept of capital allocation. You have probably heard the term “capital allocation” before. It is what public companies are constantly doing, they have limited capital in which to work with, and they have to make decisions on how to best allocate it. “Capital” can mean many different things in finance depending on the context, in this context we just mean funds that the business has acquired due to raising funding (debt or equity), or through their own operations. Understanding the concept of capital allocation is critical to understanding investing because companies that have demonstrated competence in this area tend to produce the best returns.

Below are some examples of how capital can be allocated:

• Mergers and acquisitions

• Paying down debt

• Paying dividends

• Buying back shares

• Reinvesting in the business (expanding production, research and development, hiring more employees, investing in a marketing campaign, etc.)

Every capital allocation decision has an expected payoff associated with it, and managers of businesses are trying to determine what those payoffs will be and how they can maximize them. The payoff of a capital allocation decision should exceed the cost of capital (WACC) in order for it to increase the value of the business

I think it is best to explain the concept of capital allocation using an example. Let’s use our hypothetical company from the previous section that has a WACC of 7.2% and $200M in total funds raised evenly from debt and equity. Management has 3 options in which they can allocate capital:

Option 1: Invest the whole $200M in an apartment building that they can earn rental income from. They expect to earn $20M in after-tax rental income each year for the foreseeable future.

Option 2: Acquire another business for $200M that is currently generating $10M in earnings. Management also feels that they can use their expertise in cost-cutting to increase earnings to $12M/year. The business they want to acquire has no outstanding debt.

Option 3: Pay dividends to common shareholders.

Obviously, management’s best option is Option #1. It produces the most after-tax cash flow, and it’s the only option that increases the company’s value. $20M in after-tax cash flow on a $200M investment is a 10% return, the company has a 7.2% cost of capital, so because their projected return on capital exceeds the cost to acquire capital, it is a good decision. That $20M can be returned to shareholders each year in the form of dividends, and then the apartment building can be sold in the future for $200M or possibly higher if real estate prices increase. This is clearly better than option 3 which involves just paying a dividend. Option 2 produces a 6% return ($12M/$200M), which is below cost of capital.

Option #2 also highlights the risk in valuing companies using basic financial metrics like P/E ratios. Even though earnings have increased from $10-12M/year, it doesn’t mean the business is becoming more valuable because the expected return does not exceed WACC. But if you simply apply a constant P/E ratio to a company’s earnings then you will think that it has.

If a company cannot identify any avenues to deploy their capital at a rate which is higher than their cost of capital, then their best option is to return cash to shareholders via dividends. Capital allocation is a much more complex area of finance and this section was designed to give you a quick primer on how to approach thinking about management decision-making and capital allocation decisions.