Risk and return are intrinsically linked. No one will accept additional risk without receiving an adequate increase in potential returns to compensate for that risk. Therefore, splitting the amount of risk-free return from the risk-based returns in an investment is important in determining whether risk is being properly rewarded in the expected returns for the stock.
Use the Capital Asset Pricing Model (CAPM) to measure risk-based returns. The CAPM is a commonly used tool for determining what the risk-based return for a specific stock should be.
Identify the risk-free return for an investment. Generally speaking, a high-grade bond of some sort is used to represent the risk-free rate. The most common tool is U.S. government bonds, but AAA rated corporate bonds also can be used. The rates can vary significantly between these options, which affects the computation throughout the CAPM calculation.
Compute the volatility of the stock and the average returns of comparable companies. The volatility, or "beta" of a stock, is an index of the volatility of the stock relative to comparable stocks. A "normal" stock will have a beta of 1, a less-volatile stock will have a beta less than 1 and a more volatile one will be greater than 1.
Similarly, the returns of similarly situated companies are compared with risk-free rates in the CAPM. The difficultly is in identifying the companies that are comparable to another. Size, geography and specific types of businesses should be considered in establishing the pool of comparable companies.
Use the CAPM formula.
The CAPM formula is:
r = Rf + beta x ( Km - Rf ) where r = expected return for the stock; Rf = "risk-free" rate of return; Km = return rate of the appropriate asset class
CAPM is a major and well-accepted model for computing risk-based returns, but some are critical of it, especially in academic circles. It also assumes that an investor's risk tolerance is equal from one stock to the next, which may not always be the case.
- CAPM is a major and well-accepted model for computing risk-based returns, but some are critical of it, especially in academic circles. It also assumes that an investor's risk tolerance is equal from one stock to the next, which may not always be the case.