Saturday, April 11, 2009

CAPM to PE - Theories to Prices

In a continuation of my previous post about PE's relationship to WACC, I started wondering about using the capital asset pricing model (CAPM) and it's role in actually determining a price for a security. CAPM is essentially as follows:

E(R) = RFR + beta [Rm - RFR]

E(R) is the expected rate of return (which relates to the cost of equity)
RFR is the rate of return for a 'risk free asset' (approximated with treasury bill rate)
Rm is the return for the market portfolio (or in this case, security)
beta is the standarized measure of systematic risk.

Another way of thinking of the formula is what compensation is needed for me to take on additional risk (risk premium is the Rm - RFR term). It has a very similar relationship with the Sharpe ratio in analyzing marginal utility of volatility in an overall portfolio.

If you can calculate the beta (based on volatility) to determine the expected rate of return (in an efficient market portfolio), they you can create a good valuation model for determining your expected rate of return.

As I had mentioned in my previous post, you can then extend the previous model for using WACC and PE to determine a price for your equity, essentially adding more pieces to your puzzle to get a clearer picture. This can be applied in the real world as a framework to analyze along the valuation chain to see if any key assumptions look incorrect (and avoid or capitalize on mispricings).

1 comment:

Elizabeth said...

Thank you for sharing this CAPM theroies