Valuation of Shares

1. CAPITAL ASSET PRICING MODEL
- Chintan Vadgama

2. MEANING
 The Capital Asset Pricing Model (CAPM) is used to
determine a appropriate required rate of return of
an asset, if that asset is to be added to an already well-
diversified portfolio, given that asset's non-
diversifiable risk.
 Developed by Markowitz, Sharpe, and Lintner who are
researchers credited with its development.
 It attempts to measure the risk of a security in a portfolio
sense.

3. CONT…
 The model takes into account the asset's sensitivity
to non-diversifiable risk (also known
as systematic risk or market risk), often
represented by the quantity beta (β) in the financial
industry, as well as the expected return of the
market and the expected return of a theoretical risk-
free asset.
 The core idea of CAPM is measure the
undiversifiable risk of a security which is relevant to
determine the expected return of an asset.

4. ASSUMPTIONS
 All investors are risk averse and diversification is
needed.
 All investors want to maximize wealth.
 Funds are available at risk free rate.
 Securities are perfectly divisible and liquid.
 There is perfect competition in the market
 Only systematic risk is relevant in determining the
estimate returns.

5. .
High Risk Low Risk
High return May Be Definite
Low Return No Investment May Be

6. THE CAPM MODEL
 It attempts to examine the impact of security on a
portfolio’s risk & return.
 The total portfolio can be bifurcated into systematic &
unsystematic risk.
 The latter can be eliminated by diversification and
therefore only effect of systematic risk has to be
examined.
 The magnitude of the systematic risk varies from one
security to another depending upon the sensitivity of
the security to the market fluctuations.

7. (Β), THE BETA FACTOR
 BETA:- William Sharpe has suggested that the
systematic risk can be measured by beta factor. The
Beta can be viewed as an index of the degree of the
responsiveness of the security’s returns with the market
return.
 It is calculated by relating the returns of a security with
the returns of the market.
 The more responsive the price of a security is to the
changes in the market, higher would be the Beta factor.

8. CAPM
Rs = Irf + (Rm-Irf)β
Rs = the expected return from a security.
IRF = risk free return
RM = expected return on portfolio.
β= Beta a measure of systematic risk

9. CONT…
 The model depicts that the expected rate of return
on a security consists of two parts
a) Risk Free Rate
b) Risk Premium
 The risk premium varies directly with the beta
factor and therefore higher the beta factor, greater
is the expected rate of return and vice-a-versa.

10. GRAPHICAL REPRESENTATION

11. CONT…
 The expected return for a security depends upon
three things:-
1. Time value of money
2. Reward for bearing the systematic risk
3. Amount of systematic risk.

12. SECURITY MARKET LINE
 The graphical version of CAPM is known as SML. It
represents the relationship between the beta factor and the
expected rate of return.
 With the increase in risk the risk premium increases and so
does the RRR. Therefore, the risk premium is lower for a low
beta factor and is higher for a greater beta factor.

13. FAMA & FRENCH MODEL
 A factor model that expands on the capital asset pricing
model (CAPM) by adding size and value factors in addition
to the market risk factor in CAPM.
 This model considers the fact that value and small cap
stocks outperform markets on a regular basis.
 By including these two additional factors, the model adjusts
for the outperformance tendency, which is thought to make it
a better tool for evaluating manager performance.