Capital Asset Pricing Model (CAPM): Calculating Expected Returns

Now she needs to discount these cash flows to the present, and add them up to determine a fair price for the stock. She uses the CAPM, $$\displaystyle E[R_i] = R_f + \beta_i(E[R_M] - R_f) $$, for each stock, _i_, that she's working on.

With an estimate of an asset's systematic risk, the __Capital Asset Pricing Model (CAPM)__ can be used for estimating expected or required returns for that asset. Suppose that April is using the CAPM extensively in her work. She has been working on equity valuations lately, recognizing that the value of a stock is just the discounted future cash flows. While these are hard to estimate, April feels like she has a pretty good idea of future profitability measures of a few, and she has come up with some cash flow figures that she feels pretty confident about.

Correct! A higher beta means higher systematic risk, and the CAPM immediately translates this into higher expected returns. This higher expectation becomes the discount rate, so that future cash flows are discounted more heavily. This makes the present value of these cash flows smaller, reducing the price. If that was too long a trail of thought, here's another way of looking at it. More risk means less value for the same cash flows. So lower price.

Incorrect. Think about what a higher expected rate of return means when it is used as a discount rate for bringing cash flows to the present.

Incorrect. A higher beta does mean greater risk. But that would not lower the expected return for a stock; it would necessarily increase the expected return.

April is also working on a __cost of capital__ estimation for an energy firm, which includes more than just common equity. The cost of debt and the cost of equity are both affected by firm risk, and the CAPM is her tool of choice to try to get at the right cost for common equity.

How do you think April's estimate of beta for this company will affect some of the variables she uses in her analysis?

No, not necessarily. Investors are interested in good risk-adjusted returns. A lower risk level will likely mean a lower return, sure. But investors would still be interested in a fair trade off between the two.

To summarize this discussion: [[summary]]

Considering April's process from beta estimation, to CAPM required return estimation, to discount rate, and finally to price, how would you best state the relationship that April will find between the beta of a stock she is analyzing and her estimated price of that stock?

No, the beta measure doesn't affect the risk-free rate. That is estimated separately and has nothing to do with a firm's systematic risk.

Correct! This is a logical connection once again between risk and return. The estimated beta is used for estimating the cost of equity, sure, but bondholders aren't isolated in how they view risk and return. A higher risk level for the firm will cause higher expected returns from all investors. Conversely, a lower beta will mean lower costs of equity, including debt.

A lower beta will most likely mean a lower risk-free rate

A lower beta will most likely mean a lower cost of debt

A lower beta will most likely mean less interest from investors, since they prefer higher rates of return

A higher beta means a higher required rate of return for the stock, lowering the price

A higher beta means a higher expected rate of return for the stock, increasing the price

A higher beta means greater risk, so a lower expected return for the stock, lowering the price

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