If you were valuing a stock (say to pitch a stock for the buy side), you are looking for stocks that the market has mispriced. Your aim is to have a profitable long or short strategy. Can you use the Capital Asset Pricing Model to value your stock? Two problems come to mind:

  1. CAPM assumes an efficient market. Your whole point is to spot inefficient pricing in the market.

  2. CAPM says $R_i = R_f + \beta(R_M - R_f)$. Now say we will value our stock based on the rate of return and discount future gains. We need to estimate $\beta$, which is calculated based on historical variance and correlation with the market of the return. But this return is based on market pricing. If the market pricing is wrong, then our estimate of $\beta$ will be wrong.

So we should not use CAPM while valuing stocks or doing stock pitches. Am I wrong?

  • $\begingroup$ Valuation, together with CAPM, is not a prescription. Rather, they are frameworks to arrive to a conclusion what a 'fair' value might be and use it at a negotiation table where the deal is done. $\endgroup$ – Sergey Bushmanov Feb 9 '16 at 19:43
  • $\begingroup$ @SergeyBushmanov, I agree. To arrive at an initial "fair" value for a publicly traded stock, do I use CAPM? If I do so, will I always arrive at the market price? $\endgroup$ – highBandWidth Feb 9 '16 at 19:52
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    $\begingroup$ You do realize that the CAPM is a poor empirical model right? And this has been known since the 1970s. $\endgroup$ – user32416 Feb 9 '16 at 21:38

CAPM is a model that assumes an efficient market and that the market prices securities based on the preferences of highly diversified investors. With regards to stock valuation, the usual approach is that we use some estimate of $\beta$ (the market correlated risk) to arrive at the $R_i$, which is the return on equity expected of this stock. This is the "cost of capital" on equity. This $R_i$ is weighted by the fraction of capital raised by the firm using common stock and added as a term in the WACC. i.e.,

WACC = $R_{\text{equity}}w_{\text{equity}}+(R_{\text{debt}}-T)w_{\text{debt}}$

where $T$ is the tax rate and we are ignoring preferred stock.

  • $\begingroup$ The WACC equation is wrong. And moreover, it seems to me you're confusing the concepts of levered and unlevered equity. $\endgroup$ – user32416 Feb 10 '16 at 13:31

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