CAPM, Beta, and “Really, What will Your Cash Flows Be?”

Posted by Dan Caruso
October 9, 2008

CAPM, Beta, and “Really, What will Your Cash Flows Be?”

[Follow-on to What the heck is Intrinsic Value?]

If you know what free cash flows will really be, you will be able to ascertain Intrinsic Value. In fact, “really” allows an investor to use a lower discount rate–very low in fact if you know with certainty.

Capital Asset Pricing Model (CAPM) is used to determine a theoretically appropriate required rate of return of an investment. In layman’s term, the appropriate rate of return is equal to the risk free rate of capital + a premium that is based on the riskiness of the particular investment. The premium is broken down by multiplying riskiness (which is called “beta”) by the amount of premium that an investor should expect for each unit of risk.

The term beta is a very popular term in the world of finance. “What’s the beta?” translates to “How risky is the investment?”. The more risky, the higher the return an investor will expect to make on the investment. As the expected rate of return goes up, the value of the investment today is pushed down.

Tomorrow I will bridge this discussion into why really is an important term in my definition of Intrinsic Value.

I know what you are thinking: “If that’s the layman’s version of CAPM, how weird is the non-layman’s version?” For those few who might be interested, try this on for size:

$E(R_i) = R_f + \beta_{i}(E(R_m) - R_f).\,$

Where:

$E(R_i)~~$ is the expected return on the capital asset
$R_f~$ is the risk free rate of interest
$\beta_{i}~~$ is the beta coefficient returns,
$E(R_m)~$ is the expected return of the market
$E(R_m)-R_f~$ is sometimes known as the market premium or risk premium (the difference between the expected market rate of return and the risk-free rate of return).