How to Use CAPM in Investment and Financial Analysis
Auto Beauty Business Culture Dieting DIY Events Fashion Finance Food Freelancing Gardening Health Hobbies Home Internet Jobs Law Local Media Men's Health Mobile Nutrition Parenting Pets Pregnancy Products Psychology Real Estate Relationships Science Seniors Sports Technology Travel Wellness Women's Health

How to Use CAPM in Investment and Financial Analysis

Capital asset pricing model computation
It has been about two months since I published an article. Honestly, I have been very busy building my empire, but I admit that that two months and focus was not healthy. All those time were spent exclusively to nurture a single income stream or source. As an investor, I know you are aware of the concept of diversification. Put simply, it means do not put all your eggs in one basket which was what I didn't do for the last two months.

Now, speaking of investments, in your research, have you came across a financial model called the Capital Asset Pricing Model? The Capital Asset Pricing Model or simply CAPM is one of the simplest investment and financial analysis tools ever invested. Why?

First, it is a relatively simple formula as shown below.

r = rF + β*(rM – rF)

where

r = required rate of return of a financial asset

β = the financial asset beta

rF = risk free rate

rM = required rate of return of a market portfolio

Beta is a financial asset’s degree of risk in comparison to the market while (rM – rF) is called the market risk premium which is the risk premium that an average investor demands as a result of assuming more risk than holding the risk free asset.

The convention as regards the risk free rate is to use the current yield of the 90-day United States Treasury notes.

Second, the above variables are readily available in free finance Web sites such as Yahoo! Finance and Google Finance.

In using CAPM in analyzing an investment, I follow these procedures.

  1. Determine the appropriate risk free rate to be used. As stated above, the yield of a 90-day US Treasury note is used. In my part, the risk free rate I used for computing the financial asset’s rate of return using CAPM depends on the market where the asset is. It can even depend on the planned holding period for the asset. Say, I plan to hold the asset for more than a year, and then I use the yield of a one-year US Treasury note.
  2. Determine what index best represent your market. Say, the market could be best represented by the Standard and Poor’s 500 Index, then use it. If you think the Russell 3000 is a better market representation, then use it. I usually use S&P 500 because of the ease in computing this index’ return. Moreover, I usually use a ten year period. For example, I go to Yahoo! Finance and key in ^GSPC in the Get Quote function, and then I go to the Historical Price function and look up the index’ closing prices today and ten years ago.
  3. Compute the compounded annual growth rate of the market based on the closing quotes determined in Step #2. For example, today the index’ closing price is 1,700 and ten years ago it was 1,200, therefore the compounded annual growth rate, which is also the market’s required rate of return is computed as

rM = [1 + ((1,700 – 1,200)/1,200)]^(1/10) – 1

rM = 3.54%

4. Look up for the financial asset’s beta values as computed by Yahoo! Finance and Google Finance. What I usually do is get the average of the beta figures computed by these finance Web sites.

5. Computed for the asset’s required rate of return by substituting the risk free rate, beta and required rate of return of the market in the CAPM equation presented above.

 

The take away point in this article is that in choosing the financial analysis tools and techniques to be used in evaluating a project or an asset, choose the one that best fit the situation. If you can, choose and use several tools to further validate your findings. Aside from knowing what you are getting into, you should also know what you are doing. Remember, it is your money.

Other useful references:

1. Investments: General How-To Guide

2. How to use DuPont Analysis in investment and financial analysis

Shopping online? Find the latest coupon codes for payroll, accounting & invoicing brands and score big discounts on your favorite brands. Shop through our partner network for the best discounts on popular payroll, accounting & invoicing stores with exclusive discounts, site-wide promo codes, and single-use codes.
Need an answer?
Get insightful answers from community-recommended
experts
in Accounting & Finance on Knoji.
Would you recommend this author as an expert in Accounting & Finance?
You have 0 recommendations remaining to grant today.
Comments (3)

great info, only I have no money to invest, wish I had

Hi Carol! When I was starting, having no money to invest was also a problem. What I had was a lot of determination. Now, I have left over money to invest.

alex

Good reference in planning your investment! Excellent and keep it up! congratulations

ARTICLE DETAILS
RELATED ARTICLES
RELATED CATEGORIES
ARTICLE KEYWORDS