Practical Use of a CAPM

The capital asset pricing model (CAPM) is a formula which tries to relate the risk/return trade-off with market returns. That is, a security's price should be directly related to its cost of capital. Interest rates are used as a proxy for cost of capital, and "beta" is used as a proxy for level of risk. While the calculation may sound academic, its many uses make it popular among investment practitioners.

The challenge with securities is trying to determine intrinsic value. The most salient use of CAPM is for asset pricing. Analysts and investors use it to compare against the book value (accounting value) and market value of a stock. CAPM is used as a gauge for the intrinsic value. An asset which is trading lower than its intrinsic value is a good deal.

CAPM is an important tool for project appraisal and other valuation needs as well. It is often used to compare investment projects of all different types of risk. It is superior to net present value (NPV) in many ways because it uses one discount rate for all projects, rather than leaving that up to the discretion of the project or finance manager.

CAPM, like most financial theories, comes with some assumptions. The first assumption is that investors in assets require a return above the risk-free rate. The second is that unsystematic risk (diversifiable risk) can be diversified away. Therefore, no premium should be given for it. Third, investors require higher returns from assets where systematic risk (undiversifiable risk) is greater.