The Capital Asset Pricing Model, Market Model, and Other Factor-Based Equity Models

Estimating the required return on equity: the CAPM and the market model, beta, arbitrage pricing theory and multi-factor models used in equity investing.

1. 1. Return-generating models, the market model and betaReturn-generating models link expected return to risk factors; with the market as the only factor, an asset's sensitivity to the market, its beta, measures its systematic risk.Video · 7 minFree15 min
2. 2. The CAPM: assumptions, the SML and its limitsThe CAPM says expected return depends only on beta: $E(R_i) = R_f + \beta_i[E(R_m) - R_f]$, drawn as the security market line, which prices every asset and portfolio.Video · 6 min15 min
3. 3. Estimating beta for the cost of equityThe CAPM turns a beta estimate into a company's cost of equity, so the analyst's choices in estimating beta (regression form, adjustment towards 1.0, index, horizon and return frequency) flow straight into the valuation.14 min
4. 4. Industry betas: unlevering and releveringWhen a company's own beta is noisy or unavailable, estimate the business risk of comparable companies by unlevering their average beta, then relever it at the company's own debt-to-equity ratio.13 min
5. 5. The market risk premium and the country risk premiumThe MRP is an estimate, not a fact: it can be measured from history or implied from current prices, and for markets outside the most developed ones a country risk premium is added before multiplying by beta.14 min
6. 6. APT and the four-factor model for the cost of equityMulti-factor models price several sources of systematic risk, so a stock's cost of equity is the risk-free rate plus the sum of each factor beta times that factor's premium, which can be well above or below the CAPM figure.14 min