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The Capital Asset pricing model (CAPM) calculator allows you to determine the current expected return of a specific stock factoring in the risk free rate.
|Expected return on the capital asset|
There may be a difference in intensity of risk, but most market investments, especially stocks, are always subject to risk. The capital asset pricing model (CAPM) helps you calculate the value of your investments while taking those risks into account. This is not only limited to securities, you can also evaluate any investments by this method.
This model factors in the non-diversifiable risk relating to an asset. This is also known as systematic or market risk often represented by the quantity beta (β). It also takes into account the expected return of the market as well as the expected return of the conceptual risk free asset.
The formula for calculating CAPM is as follows:
The risk free rate accounts for a theoretical rate of return on an investment that is assumed to have no risk involved. The risk free rate can be calculated by subtracting the current inflation rate during the period of your investment from yield of the treasury bond.
The risk free rate is the minimum rate that all investors expect for any investments they make. It is only theoretical because even the safest investments would carry some amount of risk, no matter how small.
Beta is the standard CAPM measure of systematic risk involved with investing in a particular stock relative to the risk of the market. The beta of stock would be 1. An individual security with the beta of .5 would have less risk, whereas beta of stock 1.5 would be riskier than the market.
This is the difference between the expected return on the market portfolio and the risk free rate.
To get the expected rate of return on the assets, the next step would be to multiply the beta by market risk premium. The risk free rate is then added to the product of beta of stock and market risk premium. This will give you the value of required/expected rate of return, which can be used to find the value of an asset.
The CAPM method is widely used because of its simplicity to evaluate the rate of return and even easy comparisons between the alternative stock investments. However, there is one major drawback when it comes to using this method. This method is based on making several assumptions that are sometimes a little far from reality.
The risk free rate, beta of stock and market risk premium all are values are theoretical. These values can easily fluctuate with factors like, market conditions and inflation.
Imagine an advisor has proposed to add the stock of 10k to your portfolio. He has used the CAPM to determine the expected rate of return or discount rate of 15%. You can take this information to compare it with past performances of that company in the market. You can also use this to make a comparison with its peers.
To continue with the example, if you find that the company has been performing with 14% to 16% over the past few years, you may consider taking the advice and adding the stock to the portfolio. In case, if you find out that the peers of the stock have performed better in the past, you shouldn't add this stock to the portfolio without proper clarifications from the advisor.
This method is also practical because it helps you identify if your portfolio is performing as per the expectations or it has grown unproportionately riskier. You can then decide to make some changes to improve the returns on investments.
The goal of CAPM calculator is to determine whether a stock is fairly valued when its expected return is compared to its risk and the time value of money.
As explained above, you will need to input the above mentioned figures in the calculator to get the expected rate of return on your capital assets. Let's take a look at how you can benefit by using the calculator:
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