One finance model used to assess an investment's attractiveness based on these two factors is the Capital Asset Pricing Model or CAPM.
CAPM equates the expected return with the market return, the risk free rate, and the relative behaviour - defined as beta (of the price of a security relative to the behaviour of the market. CAPM's basic criterion is straightforward: an investment is attractive if its risk premium (the additional return over the risk-free rate) is equal to or higher than the risk of the market.
If the risk premium is the difference between the expected return r and the risk-free rate rf, or (r - rf), and the market risk is the difference between the market's rate of return rm and the risk-free rate rf multiplied by the of the stock (Sharpe, 1964 and Lintner, 1965), then the CAPM formula can be shown as follows:
The risk premium of the security (7%) is greater than the risk premium of the market (6%). Put another way, the security's 12% anticipated return is above the expected return of 11% that makes the security attractive to an investor given its or price behaviour. According to CAPM, this security is attractive.
Empirical evidence from Sharpe and Lintner showed that the expected return of a security d...
The two sides of the CAPM equation reflect two aspects of risk, a non-diversifiable market risk and a diversifiable risk that can be minimized by holding a portfolio of securities. Beta measures risk and provides the investor with a method to assess whether the investment conforms to his/her risk appetite; a beta higher than 1 indicates that the investment is riskier than the market portfolio.
Risk appetite is one issue that affects the investment decision. Another is whether the company's share price is under- or over-valued. If analysis of the company shows that the market price of the security is under-valued relative to its intrinsic value, or that the market will continue going up over time, then an investor would willingly take on the added risk in exchange for a higher upside potential and buy the security even if CAPM shows otherwise. As Graham (p. 88) argued, the "rate of return of any investment will depend on the amount of intelligent effort the investor is willing to put into the task".
CAPM is one model used to value the attractiveness of a security by relating risk to beta. The Arbitrage Pricing Theory of Ross (1976) is another alternative to estimate a security's return based on macroeconomic factors (like inflation, interest rates, etc.) and market "noise" (rumours, news about the company, etc.). Another is the use of Discounted Cash Flow (DCF) valuation that we discuss in the next number.
Beta. Investopedia.com. Available from: http://www.investopedia.com/terms/b/beta.asp
Graham, B. (2003). The intelligent investor. New York: Harper Business.
Capital Asset Pricing Model (CAPM). Investopedia.com. Available from: http://www.investopedia.com/terms/c/capm.asp
Outline the ways risk is analysed in the various DCF