What are the limitations of using CAPM to calculate cost of equity?

The capital asset pricing model (CAPM) is a widely used method to estimate the cost of equity for a company or a project. It is based on the idea that investors demand a higher return for taking on more risk, and that the risk of an asset can be measured by its sensitivity to the market portfolio, or beta. However, CAPM has some limitations that may affect its accuracy and applicability. In this article, we will discuss four of these limitations and how they can impact your valuation decisions.

1 Assumptions and data

CAPM relies on several assumptions that may not hold true in reality, such as efficient markets, frictionless trading, homogeneous expectations, and zero taxes. These assumptions simplify the model, but they also ignore some important factors that can influence the cost of equity, such as transaction costs, market imperfections, investor preferences, and tax effects. Moreover, CAPM requires data on the risk-free rate, the market return, and the beta of the asset, which may not be easy to obtain or reliable. The risk-free rate may vary depending on the maturity and currency of the security, the market return may depend on the choice of the market index and the time period, and the beta may change over time or differ across sources.

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Aashutosh Yogi

Fund Auditor I Financial Reporting I PwC I KPMG I EY
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As per my experience and academic knowledge:- 1. CAPM assumes that the risk aversion of investors has not changed in a systematic way over time. (The risk aversion may change from year to year, but it reverts back to historical averages). 2. it assumes that the riskiness of the “risky” portfolio (stock index) has not changed in a systematic way over time. 3. Noisy estimates: Even with long time periods of history, the risk premium that you derive will have substantial standard error. For instance, if you go back to 1928 (about 78 years of history) and you assume a standard deviation of 20% in annual stock returns, you arrive at a standard error of greater than 2%: Standard Error in Premium = 20%/√ 7 8 = 2.26%

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2 Static and linear

CAPM assumes that the cost of equity is constant and linearly related to the beta of the asset. This means that the model does not account for the dynamic and nonlinear nature of risk and return in financial markets. For example, CAPM does not capture the effects of changing macroeconomic conditions, market cycles, investor sentiment, or asset-specific events on the cost of equity. It also does not reflect the possibility that investors may have different risk preferences or expectations for different levels of risk. Therefore, CAPM may not be able to capture the true risk-return trade-off for an asset or a project.

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Aashutosh Yogi

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One of the Issues with the CAPM model is that:- 1. it only captures the market risk or non-diversifiable risk and does not consider the macroeconomic factors like Risk and return both of which have a correlation Risk awareness of investors. 2. the risk that CAPM assumes is only possible for marginal investors which are well diversified but that is not the case for everyone. 3. Taxes are highly impact returns which is missing in the assumption. For example: in an Oil exploration company the most significant risk is an unsystematic risk but CAPM would only be the systematic risk. 4. beta is computed by historical data and beta is something that has a co-relation with an expected rate of return. conclusion:- imperfect, but still useful.

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3 Diversification and market portfolio

CAPM assumes that investors are fully diversified and hold the market portfolio, which is the weighted average of all risky assets in the market. This implies that investors only care about the systematic risk of an asset, which is the risk that cannot be eliminated by diversification, and not the unsystematic risk, which is the risk that is specific to an asset or a project. However, in reality, investors may not be fully diversified or hold the market portfolio, either due to practical constraints, behavioral biases, or other reasons. Therefore, investors may also care about the unsystematic risk of an asset or a project, and demand a higher return for bearing it. In addition, CAPM does not specify what constitutes the market portfolio, which may vary across regions, sectors, or asset classes.

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Aashutosh Yogi

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one thing I have found useful is that as they say " there is no free cup of coffee on Wallstreet" Hence I always believe that the market would not pay for your stupidity in investing, therefore, the market will only pay for Non-diversifiable risk that can not be taken away as it's not controllable like interest rate and inflation rate and other micro economic factor. diversifiable risk can be diversified and if we do not diversify due to any reason the market will not pay as the market has a beta of 1 and we compare this beta with our security therefore we have to diversify our risk as CAPM only assume the systematic risk and would pay for that risk only as expected return. and I believe in real life also no one pays us for our stupidity

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4 Empirical evidence and alternatives

CAPM has been tested empirically by many studies, but the results have been mixed and controversial. Some studies have found support for the model, while others have rejected it or found anomalies that contradict it. For example, some studies have found that low-beta stocks tend to outperform high-beta stocks, or that other factors, such as size, value, momentum, or quality, can explain the cross-sectional variation in stock returns better than beta. Therefore, CAPM may not be able to explain or predict the actual cost of equity for an asset or a project. As a result, some practitioners and academics have proposed or used alternative models, such as the arbitrage pricing theory (APT), the Fama-French three-factor model, or the multifactor models, to estimate the cost of equity.

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Aashutosh Yogi

Fund Auditor I Financial Reporting I PwC I KPMG I EY
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the other alternative that have been suggested like the APT or the Multificator model has their own limitation like the multifactor model has estimation uncertainty for each variable and reliability of source.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Aashutosh Yogi

Fund Auditor I Financial Reporting I PwC I KPMG I EY
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the MCPM (market-derived capital pricing model):- It is based on the premise that investors require a return for 3 types of risk:- 1. The National Confiscation Risk:- Risk that investors lose money because of national policy like a loose monetary policy which leads to inflation. 2. Corporate default risk:- Risk that the company will default result of mismanagement or independent macroeconomic consideration. 3. equity return risk:- Risk that Equity investor has a secondary or residual claim in the company in the event of liquidation or bankruptcy. Putting value on the first two risks is easy:- 1. confiscation risk:- Bond rate 2. default risk:- excess of bond yield to bond rate example company Bond yield is 5% and 4% (step1) = 5-4=1%

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What are the limitations of using CAPM to calculate cost of equity?

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1 Assumptions and data

2 Static and linear

3 Diversification and market portfolio

4 Empirical evidence and alternatives

5 Here’s what else to consider

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