the capital asset pricing model often called CAPM for short is an investment
theory that shows the relationship between the expected return of an
investment and market risk to better understand CAPM I think it will be
easier if we look at an example and how it can be used this is the formula for
CAPM and if you are of the math persuasion then perhaps this formula
makes a lot of sense but for the rest of us let's break it down to try to make it
a bit simpler so there are only three inputs that go into CAPM. first is the
risk-free rate we're going to use the 10-year Treasury note and as of now it's
September of 2018 the 10-year Treasury note is about 3% next we have beta. beta
looks at the relationship between our investment and the market for our
example we will use a stock so for us beta looks at how the stock moves
compared to how the stock market moves the market by definition gets a beta of
1 so let's use Apple stock so we can see an actual example
so apples beta is 0.99 and this is mighty close to 1 so what does this tell
us well it tells us that Apple's stock acts
very similar to the market so if the markets up 1% well then Apple stock will
be up almost 1% more exactly it should be up about 0.99% same is true on the
downside the market goes down Apple stock will be down just short of 1% and
just to see how this impacts things let's throw a second stock in there
right now Facebook has a beta of 1.2 so if the market moves up or down 1%
Facebook will move up or down 1.2% the closer the beta is to 1 the more the
stock moves like the market does the final input in our formula is the
expected return of the stock market now coming up with this number isn't always
clear some research companies publish what they expect long term market
returns to be you can also use a historical average for our case we're
going to use the average of the past 10 years which is about 9% per year
ok so now we have all of our inputs our risk-free rate is 3% beta for Apple is
0.99 and for Facebook its 1.2 and then we have the expected market return of 9%
okay so let's plug these numbers in so Rf is the risk-free rate so here we
could plug in 3 percent this symbol here this is the Greek symbol for beta for
Apple we can replace this beta with 0.99 and we could put Facebook's formula down
here and there we will put 1.2 then in the parenthesis we have the expected
market return minus the risk-free rate they call this the market premium for
the expected market return we're using nine percent and for the risk-free rate
it's the same as the three percent that we're using over here now for those
interested the horizontal bar that's above the R right here and here
well that bar indicates that this is an estimate so now we know we're using an
estimate of expected market return and that will give us an estimate of the
return of this asset that's what the lowercase a stands for and over here M
that stands for the market so when we calculate these we end up with eight
point nine percent for Apple and ten point two percent for Facebook
now don't forget the only difference between Apple's formula and Facebook's
formula is their individual beta so how can this be used well one way you can
use CAPM is to use it in calculating the WACC of a company WACC is short for
weighted average cost of capital and that WACC can be used as a discount
factor to value a stock in something like discounted cash flow now
technically for WACC you would use both the cost of debt and the cost of equity
CAPM can be used as the cost of equity so for a quick illustration as to how it
can be used let's imagine that Apple and Facebook have no debt which means that
whack for both of them is the same as CAPM let's see how that would play out
let's imagine that we had an expected cash flow coming from Apple in two years
and let's imagine that it is going to be $1,000 well since cash is more valuable
today than it is in let's say the two years well what we can do is use the
results of our CAPM calculation as a discount factor so if I'm gonna get
$1,000 in two years well for Apple using our CAPM results of eight point nine
four percent we can use that as a discount factor and we can see that that
$1000 in two years is worth eight hundred and forty two dollars and 61
cents today for Facebook if we were also expecting a thousand dollars in two
years that be worth eight hundred twenty three
dollars and forty three cents today so in theory that's the present value of
your future cash flow expectations so what you want to do is pay less than
that today and if your expectations are correct well the bigger the gap between
what you pay today and your calculated present value the bigger your returns will be
now CAPM isn't the only way to calculate a discount rate or an expected
rate of return there's also something called the arbitrage pricing theory
that's quite popular there are also a few multi-factor models at work as well
so keep in mind that CAPM is one of a few choices not the only choice at some
point in the future I'll do similar style videos to this on the arbitrage
pricing theory and multi-factor models and if you haven't done so already hit
the subscribe button and I appreciate you staying with the video all the way
to the end thanks and I'll see you in the next video