Capital Asset Pricing Model - CAPM

With the Capital Asset Pricing Model, investors determine the returns they should expect from a startup or invention

Siert BruinsSiert Bruins
Capital Asset Pricing Model - CAPM

With the Capital Asset Pricing Model (CAPM), an investor determines how much compensation he/she wants to receive for the risk undertaken. We introduced CAPM on the previous page about the important valuation method, the DCF method. Capital Asset Pricing Model is essentially an investment theory that tells you something about the required return you should aim to achieve to be compensated for the risk of investing in a startup or any business. According to the Capital Asset Pricing Model, this so-called required return is composed of a risk-free component and a premium determined by the risk inherent in the project or company. The required return can be calculated using the following formula:

r i = R f + βi(R m - R f )

Let's look at the parameters in this formula.

  1. r i is the discount rate or required return: the required rate of return.
  2. R f is the risk-free rate. For the risk-free rate, the interest on government bonds is taken if you are valuing a Dutch project or the so-called American T-bill if a project is valued in the US. You should determine for yourself which government bonds are suitable for use in your own country.The term "risk-free" is used because the government, which issues these bonds, is always expected to be able to pay the interest and principal. However, nowadays, given the developments in Greece and Ireland during the financial crisis, this is sometimes viewed with more nuance. The specific interest rate you should use, whether it's the 3-month rate, 1-year, 5-year, or longer, depends on the duration of the project.
  3. R m is the return on the (market) portfolio. The return is not always known and sometimes difficult to determine. Instead, attention is paid to the quantity (Rm - Rf), also called the risk premium. It turns out that this has averaged about 7% over time, and we will use this from now on.
  4. βi is the sensitivity or risk associated with a specific company, project, etc. βi is the sensitivity or risk associated with the expected return of investment i, and differs for each company or investment. If βi > 1, it means that the investment exhibits higher sensitivity (greater fluctuations in value) compared to the market when βi < 1. For an extensive discussion of this topic , we refer you to two books: The first is Brealey & Myers: Principles of Corporate Finance, as well as Andrew Metrick: Venture Capital and the Finance of Innovation.

The Applied Capital Asset Pricing Model

Let's take a moment to reflect on what we have so far. At the time of writing, the 5-year interest rate on a USA government bond is assumed to be 2.4%. According to the Capital Asset Pricing Model, the discount rate, ri, for a project, i, would be:

ri = 0.024 + βi * 0.07

In case we invest in a project with the same risk profile as the market, i.e. βi, this would be:

ri = 0.024 + 0.07 = 9.4%

According to the Capital Asset Pricing Model, it is important to know what the β for a project is. For existing companies, this is relatively easy because their cost of capital is known. However, inventors face a problem because they don't have a company history, cannot determine β, and therefore, don't have a cost of capital. Fortunately, experience and knowledge about the cost of capital of similar industries provide insights. No matter how new and spectacular your invention may be, it can always be categorized into a certain industry or sector that has existed for a longer time, and for which data are available.

The table below shows a few cost of capital values (discount rates) for different sectors. As you can see, the values vary greatly, from 5.83% for the soft drinks industry to as much as 18.14% for E-commerce.

Type of Industry and Cost of Capital (r)

  • Advertising: 9.03%
  • Auto Parts: 7.69%
  • Beverage (alcoholic): 6.43%
  • Beverage (soft drink): 5.83%
  • Biotechnology: 10.28%
  • Computer Software/Services: 13.13%
  • Computers and Peripheral Equipment: 13.43%
  • Drug: 10.05%
  • E-commerce: 18.14%
  • Electrical Equipment: 8.27%
  • Electronics: 10.24%
  • Entertainment: 9.58%
  • Entertainment: Tech 12.78%
  • Environmental: 6.31%
  • Healthcare Information: 8.67%
  • Home Appliance: 7.12%
  • Household Products: 7.27%
  • Information Services: 8.30%
  • Internet: 16.56%
  • Medical Services: 7.57%
  • Medical Supplies: 8.09%
  • Office Equipment/Supplies: 7.52%
  • Pharmacy Services: 7.66%
  • Semiconductor: 16.24%
  • Telecom. Equipment: 14.82%
  • Wireless Networking: 13.58%

Using the table above and the earlier data, we can now solve the question of whether it's better (according to the Capital Asset Pricing Model) to invest our money in the bank or in the biotechnology company. However, in the latter case, it is necessary to perform a valuation of the company. We will do this on a next page using a spreadsheet to calculate the Net Present Value (NPV), but first, one more thing. Many will wonder about the purpose of such a table if the risk profile, β, or the "risk-free rate," Rf, can change on a daily basis. This is a valid question; however, it must be said that you can reasonably work with these average values for the cost of capital because in the long run, the values will fluctuate around this average. However, you will need to check if these numbers are still valid. Risk profiles of both investors and companies can change.