The Capital Asset Pricing Model: an Overview

No matter how much we diversify our investments, it's impossible to get rid of all the risk. As investors, we deserve a rate of return that compensates us for taking on risk. The capital asset pricing model (CAPM) helps us to calculate investment risk and what return on investment we should expect. Here we take a closer look at how it works.

Birth of a Model

The capital asset pricing model was the work of financial economist (and later, Nobel laureate in economics) William Sharpe, set out in his 1970 book "Portfolio Theory and Capital Markets." His model starts with the idea that individual investment contains two types of risk:

1. Systematic Risk – These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.
   
2. Unsystematic Risk – Also known as "specific risk," this risk is specific to individual stocks and can be diversified away as the investor increases the number of stocks in his or her portfolio. In more technical terms, it represents the component of a stock's return that is not correlated with general market moves.

Modern portfolio theory shows that specific risk can be removed through diversification. The trouble is that diversification still doesn't solve the problem of systematic risk; even a portfolio of all the shares in the stock market can't eliminate that risk. Therefore, when calculating a deserved return, systematic risk is what plagues investors most. CAPM, therefore, evolved as a way to measure this systematic risk.

The Formula

Sharpe found that the return on an individual stock, or a portfolio of stocks, should equal its cost of capital. The standard formula remains the CAPM, which describes the relationship between risk and expected return.
Here is the formula:

CAPM's starting point is the risk-free rate – typically a 10-year government bond yield. To this is added a premium that equity investors demand to compensate them for the extra risk they accept. This equity market premium consists of the expected return from the market as a whole less the risk-free rate of return. The equity risk premium is multiplied by a coefficient that Sharpe called "beta."

Beta

According to CAPM, beta is the only relevant measure of a stock's risk. It measures a stock's relative volatility – that is, it shows how much the price of a particular stock jumps up and down compared with how much the stock market as whole jumps up and down. If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10% and fall by 15% if the market fell by 10%.
Beta is found by statistical analysis of individual, daily share price returns, in comparison with the market's daily returns over precisely the same period. In their classic 1972 study "The Capital Asset Pricing Model: Some Empirical Tests," financial economists Fischer Black, Michael C. Jensen and Myron Scholes confirmed a linear relationship between the financial returns of stock portfolios and their betas. They studied the price movements of the stocks on the New York Stock Exchange between 1931 and 1965.
Beta, compared with the equity risk premium, shows the amount of compensation equity investors need for taking on additional risk. If the stock's beta is 2.0, the risk-free rate is 3%, and the market rate of return is 7%, the market's excess return is 4% (7% - 3%). Accordingly, the stock's excess return is 8% (2 X 4%, multiplying market return by the beta), and the stock's total required return is 11% (8% + 3%, the stock's excess return plus the risk-free rate).
What this shows is that a riskier investment should earn a premium over the risk-free rate – the amount over the risk-free rate is calculated by the equity market premium multiplied by its beta. In other words, it's possible, by knowing the individual parts of the CAPM, to gauge whether or not the current price of a stock is consistent with its likely return – that is, whether or not the investment is a bargain or too expensive.

What CAPM Means for You

This model presents a very simple theory that delivers a simple result. The theory says that the only reason an investor should earn more, on average, by investing in one stock rather than another is that one stock is riskier. Not surprisingly, the model has come to dominate modern financial theory. But does it really work?
It's not entirely clear. The big sticking point is beta. When professors Eugene Fama and Kenneth French looked at share returns on the New York Stock Exchange, the American Stock Exchange and Nasdaq between 1963 and 1990, they found that differences in betas over that lengthy period did not explain the performance of different stocks. The linear relationship between beta and individual stock returns also breaks down over shorter periods of time. These findings seem to suggest that CAPM may be wrong.
While some studies raise doubts about CAPM's validity, the model is still widely used in the investment community. Although it is difficult to predict from beta how individual stocks might react to particular movements, investors can probably safely deduce that a portfolio of high-beta stocks will move more than the market in either direction, and a portfolio of low-beta stocks will move less than the market.
This is important for investors – especially fund managers – because they may be unwilling to or prevented from holding cash if they feel that the market is likely to fall. If so, they can hold low-beta stocks instead. Investors can tailor a portfolio to their specific risk-return requirements, aiming to hold securities with betas in excess of 1 while the market is rising, and securities with betas of less than 1 when the market is falling.
Not surprisingly, CAPM contributed to the rise in use of indexing – assembling a portfolio of shares to mimic a particular market – by risk-averse investors. This is largely due to CAPM's message that it is only possible to earn higher returns than those of the market as a whole by taking on higher risk (beta).

The Bottom Line

The capital asset pricing model is by no means a perfect theory. But the spirit of CAPM is correct. It provides a usable measure of risk that helps investors determine what return they deserve for putting their money at risk.

Next Read : DCB Bank - Q4FY18 Results - Another Quarter of Robust Performance
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DCB Bank - Q4FY18 Results - Another Quarter of Robust Performance

DCB Bank continued to deliver healthy performance on all major metrics in 4QFY18 as well led by (a) strong growth in loan book (+28.6% YoY & 9.4% QoQ); (b) all-time high NIMs of 4.16% in FY18 vs. 4.04% in FY17; (c) strong growth in other income (+33.4% YoY & 13.2% QoQ); (d) continued sequential improvement in C/I ratio to 59.4% vs. 62.3% in 3QFY18; and (e) lower fresh slippages of Rs805mn vs. Rs1,031mn in 3QFY18. Led by 70% YoY and 16% QoQ improvement in upgrades and recovery from gross NPA to Rs667mn, its headline gross and net NPA ratio came in at 1.79% and 0.72%, respectively compared to 1.89% and 0.87% in 3QFY18. The Bank’s overall stressed loan portfolio, which improved sequentially, remains within the Management’s comfort zone. 

Management Commentary & Guidance

• Loan book grew by 28.6% YoY and 9.4% QoQ to Rs203.4bn aided by CV, AIB, Corporate Banking and SME segments. Expecting 22-25% growth in loan book in FY19E, the Bank looks forward to double its loan book over the next 3-3½ years.

• All-time high NIMs is attributable to some attractive refinancing options used by the Bank. The Management expects NIMs to remain in 3.7-3.8% range on sustainable basis. The Bank expects cost of fund to stabilise at around current level.

• The Bank opened 56 new branches in FY18 and has completed physical expansion drive started in 2QFY16. Going forward, the Bank will expand branch network in a suitable manner without affecting its overall cost to income ratio as well as profitability.

• The Bank expects C/I income to improve owing to likely improvement in operational efficiency of existing branches and other distribution channels. It expects to reach C/I ratio of 55% by FY19-end from 59.4% in 4QFY18.

• The Management is quite comfortable till the gross NPAs remain below 2% and net NPA below 1%, as the Bank’s customers are predominately SME and mid-size business houses. 

• Its core fee income is likely to grow at healthy pace in next few quarters led by strong growth in income from sale of Priority Sector Lending Certificate and 3rd party product distribution.

DCB-Bank-Price trend 

Outlook & Valuation

Continuing to focus on increasing loan book in low-ticket Retail, SME and AIB segments, the Bank is augmenting its footprint both on physical and digital front. Though this aggressive expansion strategy might impact its return ratios in the near-term, we believe it is beneficial from long-term perspective. Further, the Management focuses on increasing efficiency of existing network to improve cost to income ratio in the long-term, which will lead to sustained earnings growth. As creditworthiness of its core client group from SME/MSME segment is steadily improving post GST roll-out, we expect further improvement in Bank’s operating performance. Rolling over our valuation to FY20E, we reiterate our BUY recommendation on the stock with a Target Price of Rs247 based on 2.4x FY20E Adjusted book value.

Next Read : Mindtree - Q4FY18 Results Update - Excellent Operating Performance Continues

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Mindtree - Q4FY18 Results Update - Excellent Operating Performance Continues

Mindtree has posted a healthy performance in 4QFY18. Its revenue grew by an impressive 5.6% QoQ (4.5% in CC terms) to US$226.2mn (exceeding our estimate by 1.4%) led by superb show in key verticals i.e. Travel & Hospitality (+9.9% QoQ), Technology, Media & Services (+9.3% QoQ) and MFG, Retail & CPG (+6.4% QoQ) in USD terms. On the flip side, BFSI revenue declined by 3.4% QoQ, which the Management believes to be a one-off. Aided by impressive revenue growth, favourable currency movement and higher utilisation, its EBITDA margin expanded by 103bps QoQ to an 8-quarter high of 16.1%, Notably, margin growth is followed by 348bps QoQ expansion in the previous quarter, driving confidence on FY19 margin trajectory, with revenue growth being the key lever. Mindtree won its single largest contract from a US airline customer. The company won deals worth US$298mn in 4QFY18 (+42.6% YoY). The Management’s expectation of even growth along with margin expansion in FY19E vs. FY18 led by healthy revenue growth is a major positive, in our view. Good revenue visibility across all verticals, strong deal wins and high digital component drive our confidence further.

Healthy Operating Metrics All-Round

From volume and pricing perspective, its blended volumes grew by a robust 7.8% QoQ, while blended pricing declined by 1.9% QoQ. Going forward, Mindtree is stepping up usage of automation and use of tools to reduce efforts for the same volume, which is likely to lead to a sustainable improvement in pricing, especially in ‘run-the-business’ projects, where clients look for cost savings. Mindtree has started disclosing the number of BOTs in operation, which stood at 335 as of FY18-end.

Mindtree added a gross of over 1,100 employees in 4QFY18 (with net addition of 523 employees) taking total headcount to 17,723 as of FY18-end. Employee utilisation came in higher, with ex-trainee utilisation at 75.1% (vs. 74.3% in 3QFY18), while cum-trainee utilisation came in at 73.8% (vs. 72.8% in 3QFY18). Management is comfortable with the current utilisation rate.

Outlook & Valuation

Greater confidence on margin growth led by robust business momentum is the key positive for Mindtree, in our view. Further, strong order book and good revenue visibility across verticals drive our confidence on healthy growth over FY18-FY20E. Notably, the growth is expected to be evenly spread out in FY19E rather than being back-ended. Hence, we believe that strong exit rate in 4QFY18 will drive >16% USD revenue growth and >200bps expansion in EBITDA margin in FY19E.Upgrading our EPS estimates by 4%/14% for FY19E/FY20E, respectively and applying a target PE multiple of 20x FY20E EPS, we maintain our BUY recommendation on the stock with a revised TP of Rs1,000.

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