Even as we agree to disagree about the usefulness or lack of the same of CAPM betas, let us reach consensus on a fundamental fact. To ignore risk in investments is foolhardy and not all investments are equally risky. Thus, no matter what investment strategy you adopt, you have to develop your own devices for measuring and controlling for risk. In making your choice, consider the following:a. Explicit versus implicit: I know plenty of analysts who steer away from discounted cash flow valuation and use relative valuation (multiples and comparable firms) because they are uncomfortable with measuring...
Alternatives to the CAPM: Part 5. Risk Adjusting the cash flows
In the last four posts, I laid our alternatives to the CAPM beta, but all of them were structured around adjusting the discount rate for risk. Having made this pitch many times in the past, I know that there are some of you who wonder why I don't risk adjust the cash flows instead of risk adjusting the discount rate. The answer to that question, though, depends on what you mean by risk adjusting the cash flows. For the most part, here is what the proponents of this approach seem to mean. They will bring in the possibility of bad scenarios (and the outcomes from these scenarios) into the expected...
Alternatives to the CAPM: Part 4: Market-Implied cost of equity
As you can see from each of the alternatives laid out in the previous three parts, there are assumptions and models underlying each alternative that can make users uncomfortable. So, what if you want to estimate a model-free cost of equity? There is a choice, but it comes with a catch.To see the choice, assume that you have a stock that has an expected annual dividend of $3/share next year, with growth at 4% a year and that the stock trades at $60. Using a very simple dividend discount model, you can back out the cost of equity for this company from the existing stock price:Value of stock ...
Alternatives to the CAPM: Part 3: Connecting cost of debt to cost of equity
Analysts have generally had an easier time estimating the cost of debt than the cost of equity, for any given firm, for a simple reason. When banks lend money to a firm, the cost of debt is explicit at least at the time of borrowing and takes the form of an interest rate. While it is true that this stated interest rate may not be a good measure of cost of debt later in the loan life, the cost of debt for firms with publicly traded bonds outstanding can be computed as the yield to maturity (an observable and updated number) on those bonds.Armed with this insight, there are some who suggest that...
Alternatives to the CAPM: Part 2: Proxy Models
The conventional models for risk and return in finance (CAPM, arbitrage pricing model and even multi-factor models) start by making assumptions about how investors behave and how markets work to derive models that measure risk and link those measures to expected returns. While these models have the advantage of a foundation in economic theory, they seem to fall short in explaining differences in returns across investments. The reasons for the failure of these models run the gamut: the assumptions made about markets are unrealistic (no transactions costs, perfect information) and investors don't...
Alternatives to the CAPM: Part 1: Relative Risk Measures
The Capital Asset Pricing Model (CAPM) is almost fifty years old and it still evokes strong responses, especially from practitioners. In academia, the CAPM lives on primarily in the archives of old journals and most researchers have moved on to newer asset pricing models. To practitioners, it represents everything that is wrong with financial theory, and beta is the cudgel that is used to beat up academics, no matter what the topic. I have never been shy about arguing the following:a. The CAPM is a flawed model for risk and return among many flawed models.b. The estimates of expected return...
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Margin of Safety: An alternative risk assessment tool?
I have lost count of the number of times I have been taken to task for not mentioning "margin of safety" in my valuation and investment books. In general, the critique is usually couched thus: "Instead of using beta or some other portfolio theory risk measure, why don't you look at the margin of safety?". While I see the intuitive value of paying heed to the "margin of safety", I don't see the two as alternative measures of risk. In fact, I think that risk measures in valuation and margin of safety play very different roles in investing.I know that "margin of safety" has a long history in...
