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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?

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

For the question of stock pitches, you can use anything you like as long as you do not commit fraud. If you believe the fact that the founder was born under the sign of Aquarius and the moon is currently in Capricorn and you don't care that you will sound like a lunatic, you can use that as well.

For valuation, you should never use the CAPM. Fama and MacBeth decisively falsified it in 1973.

Fama, Eugene F.; MacBeth, James D. (1973). "Risk, Return, and Equilibrium: Empirical Tests". Journal of Political Economy. 81 (3): 607–636

Finance has been trapped in the same place physics was trapped in following the Michaelson-Morley experiments. It was clear that classical physics was wrong, but until Planck and Einstein, the system was trapped.

You should value a security using the discounting of cash flows. I could go into why the CAPM has to be incorrect, but that isn't relevant. Once you know that something has decisively been shown to be false, then you are a fool to continue to use it.

For that matter, you cannot even find $\alpha$ because there is no $\beta$.

Also, do not use WACC. You need to know the marginal cost of capital. Using a weighted average is no different than including sunk costs in a pricing decision.

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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.

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  • $\begingroup$ 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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