Warning: the City's formula for pricing shares is bust

By Deputy editor Tim Bennett Sep 19, 2011

Tim Bennett

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Tim Bennett looks at the 'capital asset pricing model' - or CAPM - a key tool used to help analysts value shares, and explains why it doesn't work.

• Watch all of Tim's video tutorials here

Capital asset pricing model (CAPM)

The capital asset pricing model has been widely used for many years by the global financial services industry to try and predict the returns you should expect from a stock. If a stock offers a return above that predicted by CAPM you should buy it and vice versa.

The starting point for a stock's expected return is the minimum 'risk free' return an investor should expect from medium-dated AAA government bonds, say 5%. You then add a premium, because stocks in general are riskier than bonds. This figure is heavily debated, but let's say it is 3%. Now you adjust that extra premium for a stock's specific beta, say 1.2. So the expected CAPM return here would be 8.6% (5% + (3% x 1.2)). If you expect the stock you are reviewing to deliver, say, a 10% annual return, then it's a buy, says CAPM.

• Definition taken from MoneyWeek's Financial Glossary

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Published in Video tutorials | More articles by Tim Bennett

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  • 1. Yerox

    (19 November 2011, 01:02PM)  Complain about this comment

    Tim,

    You make some excellent points but surely if the risk free rate of return is now unreliable, that automatically makes shares more attractive. Let's assume the RFR is 0, then there's no point buying gilts or US Tbills.

    Secondly, if we assume RFR is zero, ERP less RFR will be higher than just RFR. So shares will still most likely to give a higher rate of return.

    Regards

  • 2. Impromptu

    (02 January 2012, 03:54PM)  Complain about this comment

    Or to put Yerox's point another way:

    T-bills are swamped by "safe-haven" buying and therefore the yield has dropped to the point whereby you are actually lending to the US govt for the privilege of your money being eroded by inflation. (The buzzphrase, of course, is that return OF capital is currently more important than return ON capital.)

    If RFR is thus depresssed, wouldn't that suggest that minimum returns valued by this method are likewise depressed? By extension, is it any surprise that institutional equity analysis is more pessimistic than it perhaps should be?

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