Introduction Many companies exist in the present and not all companies perform as well as others. The performance of companies is a critical area for some, mainly the investors who have invested capital amounts into the company. Investors can use a wide variety of tools to measure performance, but mainly focus on financial analysis, including ratio analysis, as well as other finance tools such as the Capital Asset Pricing Model (CAPM)…
It is assumed that the reader has basic knowledge of these tools of analysis. Capital Asset Pricing Model (CAPM) According to Rai University: “The CAPM was developed to explain how risky securities are priced…CAPM aims at a more practical approach to stock valuation.” The assumptions of CAPM include: 1. Investors hold diversified portfolios 2. Single-period transaction horizon 3. Investors can borrow and lend at the risk-free rate 4. Perfect capital market (Rai University, 2013) Capm reflects that investors need to be compensated in two ways Time Value Of Money Risk (Investopedia, n.d.) The risk-free (rf) rate in the formula represents the time value of money invested at a minimum rate while the other half of the formula represents market risk applicable to the company. CAPM is in the view that the expected return of a stock is equal to the rate on a risk-free stock plus a risk premium. If the expected return does not match or meet the required return then any such investment is termed to be not feasible and is not to be carried out. The betas calculated in the attached working represent the risk of the specific company in relation to the market. When coupled with the market equity risk premium and the risk free rate, we can establish a minimum rate of return that would be required by the shareholders in relation to risk and returns in the market The calculated ROE of both companies is in the 5%-7% range showing that the companies’ shareholders require a minimum return of 5% as compared to the risk and return level they face in their investment in the company’s stock. CAPM is not an absolute model as it faces many limitations. It assumes markets are information efficient and all investors preferences are the same. These assumptions may not hold true in the actual market place and so, there are other models to calculate required return on equity, such as the gorden growth model or the earnings multiplier model. The major assumption in CAPM relates to perfect capital market and the assumption of all perfect information being available to investors. This introduces the concept of efficient market hypothesis. Efficient Market Hypothesis - EMH Many different theories state that it is simply impossible to beat the market. This is mainly due to the fact that market efficiency leads share prices to reflect all relevant information at any given time. The Efficient Market Hypothesis believes that all the stock traded always hold their fair value hence it is impossible for the buyer to purchase undervalued stocks or for the seller to sell at an overvalued price as stated by Malkiel, 2003. Due to this the only way that any investor may get a higher return is by getting hold of high risk stocks or a balanced portfolio (Pesaran 2010) On the other hand people against the hypothesis highlight the example of Warren Buffet beating the market consistently over fairly long periods (CBS, 2012). “Beating the market” is considered impossible under the efficient market hypothesis. Another aspect highlighted by those against the theory is events of 1987 during which the Dow Jones Industrial Average fell by more than one fifth in a day. This gives proof that the prices of stock may show a deviation from their fair values. Efficient Marke ...
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