Capital Asset Pricing Models

Topics: Capital asset pricing model, Financial markets, Investment Pages: 5 (1684 words) Published: September 5, 2010
Running head: PRICING MODELS

Pricing Models

Adam F. Thornton

FIN 501 – 3

TUI University

Dr. William Anderson

Chipotle Mexican Grill (CMG) is one of the fastest growing restaurant chains in the United States. Self proclaimed as “fast-casual,” CMG offers a dining experience that is unique, organic, and which draws from the local economy. For the investor, CMG is a wise investment for the aggressive and fast growing portion of a portfolio. When determining an appropriate model to evaluate CMG’s potential, the Capital Asset Pricing Model (CAPM) is the best choice. This model offers the best amount detail while maintaining the simplicity needed for a model outlining investment decisions in CMG.

The Pricing Models

There are three pricing models to discuss when evaluating CMG: dividend growth, CAPM, and the Arbitrage Pricing Theory (APT). Each of these models has both advantages and disadvantages, easily tailoring one model to different situations. However, the CAPM is best suited for this case with CMG. Below is a further review on each of models’ advantages and disadvantages, and applicability to CMG’s market position and financial situation.

The Gordon Growth Model

The Gordon Growth Model (GGM) is a very simple model for estimating the value of a stock. This equation works by calculating the stock value from dividends per share, the required rate of return for the equity investor, and growth rate in dividends (Gordon, 2008). The equation looks like this: Stock Value (P) = D / (k-G). Where D is the expected dividend per share one year from now, k is the required rate of return for the equity investor, and G is the growth rate in perpetuity. This dividend growth model is best suited for a firm growing at a rate comparable to or lower than the nominal growth rate in the economy and which have well established dividend payout policies that they intend to continue in the future (Dividend). In addition, the dividend growth model is also suited for businesses that are in a stable market (Dividend). A good example of this type of company could be 3M or General Electric. Both of these companies are stable and have a steady growth rate. Moreover, these two companies are subject to various regulations and restrictions from multiple government agencies that also have a factor in limiting the growth of the corporation.

The GGM is not the preferred analysis tool for CMG for a few reasons. First, CMG has only been a public company for almost six years. This does not give enough data points to convince the investor on the direction of the company. The investor is unable to judge what CMG will do in the near and long-term regarding the growth of the company. Currently, CMG has a very high growth rate. CMG is adding over 130 restaurant locations in 2010 alone, not to mention beginning business ventures in the international market (Annual, 2009). This high growth rate deters the wise investor from using the GGM to analyze CMG. Lastly, CMG is not in a market regulated on the rate of company growth. CMG can legally build as many new restaurants that are humanly possible (fair financial practices assumed). The high growth rate that CMG has creates a mathematical problem for the GGM because it will drive the price exponentially higher. This also invalidates the accuracy of the assessment and drives the investor to use a different tool.

The Arbitrage Pricing Theory

The Arbitrage Pricing Theory (APT) also is not the right choice for CMG, though it came in close second place. The APT works by calculating the expected return of an asset with the following equation: E[Ra] = R f + ß a(E[Rm] - R f). In this equation, E[Ra] is the expected return of the investment, Rf is the risk free rate, ß a is the beta of the investment, and E[Rm] is the expected return on the market. Furthermore, this theory produces another equation: r = rf + β1f1 + β2f2...
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