Capital Asset Pricing Model (CAPM) Versus the Discounted Cash Flows Method Managerial Analysis/BUSN 602
Capital asset pricing model or CAPM is a financial model that measures the risk premium inherent in equity investments like common stocks while Discounted Cash Flow or DCF compares the cost of an investment with the present value of future cash flows generated by the investment with the mindset being that if the cash flow is positive, then the investment is good. Generally speaking, CAPM is a model that describes the relationship between risk and expected return and DCF is a valuation method used to estimate the attractiveness of an investment opportunity. So what are the differences, advantages and disadvantages of each one? How do you go about applying them? They each have their own purpose. Let’s first take a look at CAPM. “CAPM is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.”("Capital asset pricing,") It looks at the risk and rates or return and compares them to the stock market. While it is impossible to have no risk, CAPM helps calculate investment risk with the return on investment that is predictable and expected. “The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken.” ("Capital asset pricing,") So how does the model work? CAPM starts with the idea that individual investment contains two types of risk. The first is a systematic risk which is market risks that cannot be diversified away. Examples of systematic risks include interest rates, recessions and wars. “The second is an unsystematic risk or specific risk that is specific to individual stocks and can be diversified away as the investor increases the number of stocks in his or her portfolio. In more technical terms, it...
Please join StudyMode to read the full document