Capital Asset Pricing Model vs. Discounted Cash Flow Method 2

There are several financial tools and methods a financial analyst can use to help them make investment decisions and help them determine the most attractive investments for a firm. When analyzing the cost of equity and the value of companies, managers can use and compare the Capital Asset Pricing Model (CAPM) and the Discount Cash Flow (DCF) method.

CAPM is a model that describes the relationship between risk and the expected return and is used when pricing risky securities. With CAPM, investors are looking to be compensated in two ways: time value of money and risk. The time value of money is represented by a risk-free rate that compensates the investor for placing money in any investment over a period of time. Risk is also calculated as the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium.

ra=rf + ??(rm-rf) where (rf =Risk Free Rate, ??=Beta of the security, and

rm=Expected Market Return).

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 (Investopedia). An example would be if you had a stock with a risk-free rate of 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, then the stock is expected to return 17%.

(3%+2(10%-3%)) =17%.

Capital Asset Pricing Model vs. Discounted Cash Flows Method 3

Discounted Cash Flow (DCF) method is an approach to valuation, whereby projected future cash flows (cash left over for stockholders), are ???discounted??? at an interest rate (also called rate of return) that reflects the perceived riskiness of the cash flows. The discount rate reflects two things: 1) the time value of money (investors would rather have cash immediately than have to wait and must therefore be compensated for the delay) and 2) a risk premium that reflects the extra return investors demand because they want to be compensated for the risk that the cash flow might not materialize. The DCF analysis will represent the net present value (NPV) of the total expected cash flows available to all providers of capital, net of the cash needed to be invested for generating the projected growth.

Used over time, both DCF (texted after the 1929 market crash) and CAPM (developed in 1960 by William F. Sharpe) are still debated today. CAPM focuses on what might happen externally to the business such as the volatility of the market (beta) and the DCF model focuses on internal factors to establish valuations. Also, CAPM is concerned with growth rate, while DCF is concerned with estimated returns. When measuring the value of companies, investors should check for errors in the models used for DCF such as forecast horizons that are too short, uneconomic continuing value, cost of capital, improper reflection of other liabilities, discount to private market value and double counting to name a few (Mauboussin, 2006). Estimating the cost of equity (CAPM) can be challenging from the standpoint of estimating the equity risk premium and Beta. With all things equal, finance theory associates a higher beta with higher risk and reward. But, there is a practical failure as to what beta to actually use in the CAPM. Ideally, we want forward-looking betas, which we cannot reliably estimate. The same applies to the equity risk premium, which is the return above and beyond the risk-free rate an investor expects to earn

Capital Asset Pricing Model vs. Discounted Cash Flows Method 4

Exhibit 1.1 | Advantages | Disadvantages |

Discounted CashFlow Method | Theoretically, the most sound method of valuation | Accuracy of valuation highly dependent on the quality of the assumptions regarding FCF, TV, and discount rate |

| Forward looking and depends on future expectations rather than historical results | Due to quality of assumptions values are expressed in ranges rather than a single value |

| Looks inward relying on fundamental expectations of the business or asset, and to a lesser degree of external volatility | The time value often represents a large % of the total DCF valuation. So valuations largely dependent on time vs. operating assumptions for the business or asset |

| Focused on cash flow generation and less affected by accounting practices and assumptions | |

| Allows for expected operating strategies to be factored into the valuation | |

| Allows different components of a business or synergies to be valued separately | |

as compensation for assuming greater risk, it is ideally a forward-looking estimate. Many investors rely on the past which may not give a reasonable sense of return outlook.

Ultimately, both CAPM and DCF are economic models that seek to measure the same thing and they both have many advantages and disadvantages (Exhibit 1.1 and Exhibit 1.2). There may be merit to the idea of using both models to estimate the cost of equity in many cases. While CAPM is a widely accepted tool for estimating cost of equity, it has certain strengths and weaknesses and could be complemented by a DCF model.

Capital Asset Pricing Model vs. Discounted Cash Flows Method 5

In theory, both approaches seek to estimate the true cost of equity for a firm, and if applied correctly should produce the same expected results. The two approaches simply take different paths towards the same objective.

Therefore, by taking the average of the results from the two approaches, we might be able to obtain a more reliable, less volatile, and ultimately superior estimate than by relying on either model standing alone (Federal Register, 2008). If different results happen, then judgment would come into play for the analysts.

Exhibit 1.2 | Advantages | Disadvantages |

Capital Asset Pricing Model | CAPM considers only systematic risk in which most of today??™s investors have diversified portfolios. | Assigning values to the CAPM variables such as risk-free rate of return, the return on the market, or the equity risk premium and the equity beta |

| CAPM generates a theoretically-derived relationship between required return and systematic risk which has had frequent empirical research and testing | When using CAPM in investment appraisal, it is hard to calculate a project-specific discount rate |

| Seen as having the best method of calculating the cost of equity because it takes in the systematic risk relative to the stock market as a whole | In investment appraisal the assumption of a single-period time horizon is at odds with the multi-period nature of investment appraisal. |

| CAPM is better than the WACC (weighted average cost of capital) in providing discount rates for use in investment appraisal | |

Capital Asset Pricing Model vs. Discounted Cash Flows Method 6

References

Brealey, R. A., Myers, S. C. & Marcus, A. J. (2009). Fundamentals of Corporate Finance

New York, NY. McGraw-Hill Irwin.

Brigham, E. & Ehrhardt, M. C. (2010). Financial Management: Theory and Practice.

pp. 356, 357. Mason, OH. Cengage Learning

Head, T. (2008). CAPM: Theory, Advantages, and Disadvantages. Student Accountant

June/July 2008.

Investopedia. Capital Asset Pricing Model-CAPM Retrieved on

May, 18, 2011. www.investopedia.com

Lederer, P. & Mehta, T. D. (2005). Economic Evaluation of Scale Dependent Technology

Investments. Production and Operations Management; Spring 2005; 14, 1;

ABI/INFORM Global

Mauboussin, M. J. (2006). Common Errors in DCF Models: Do You Use Economically Sound

and Transparent Models Legg Mason. Capital Management. www.leggmasonfunds.com

Use of a Multi-Stage Discounted Cash Flow Model in Determining the Railroad Industry??™s

Cost of Capital. Federal Register, Feb. 13, 2008 vol. 73, No 30.