The CAPM is the graphically represented by the security market line (SML), which shows the expected rate of return for the individual security as a function of systematic risk (indicated by the beta of the security). The SML is shown in the following figure.
Suppose an investment was made in a stock with a beta of 1.5. Assuming the return on the market portfolio at 12%, and the return on the one-year treasury bond benchmark rate to be 8%, the rate of return the investor may expect on the stock would be determined by application of the CAPM as:
The stock investment is therefore expected to contribute a return of 14% to the investor’s portfolio, which is an improvement over the market return of 12%. The determination of return on the stock is important not only to balance out the portfolio, but also to enable the investor to determine the value of the stock. Knowing the value will enable the investor to decide whether or not he should purchase (or sell) the stock at the current market price. The expected rate of return is useful in the discounted dividend stock valuation method. Assume the stock’s regular per share cash dividend is $1 per annum without further growth, then the stock is priced fairly at:
The price of $ 7.14 is indicative of the value of the investment at the time of consideration, and it may or may not be equal to the price of the stock presently prevailing in the market (exchange). This is then the basis for deciding what investment action to take in the asset. If the market price is presently $9 then the market overvalues the stock, and it would be a good time to sell the stock, but not a good time to buy. On the other hand, if the market price were $6, then the market underprices the stock and it would be a good time to buy, but not to sell, the stock.
The CAPM is a theoretical model and like all theoretical models depends on some important assumptions. The following eight