Capm, Dgm, APT
There are three primary means by which a company's cost of equity can be calculated. These are the capital asset pricing model (CAPM), the dividend growth model (DDG) and the arbitrage pricing theory (APT). Each of these methods has certain advantages and disadvantages. This paper will analyze these three models in the context of their usefulness in determining the cost of capital.
The first method, and the most popular, is the capital asset pricing model. At the core of the model is the assumption that the value of a firm's share is determined by the expectation of future returns. The firm's value is therefore determined by a combination of market risk and firm-specific risk. These elements, along with the risk free rate, form the core of the CAPM equation. The capital asset pricing model uses the beta, ?, which is the historic correlation of the firm's stock price and the performance of the market. The beta is calculated on the basis of daily moves, and is constantly changing as a result. However, the beta is easy to obtain because it is a commonly published statistic. For any publicly-traded company, the beta will be posted on the Internet. The other variables in CAPM are the risk free rate, usually a short-term Treasury rate, and the historic market risk premium. This is often taken as 7%, although there are sometimes specific figures available for major indexes. Either way, it is important to remember that all of the variables in CAPM are easy to obtain, and this ease of use is one of the most important advantages that CAPM has. Another advantage, of course, lies in the assumption that the firm's cost of capital is related to its past performance.
This model is based on the assumption that the only future cash flows that contribute to a share's price are the known cash flows. These are taken to be the current dividend, and the known growth rate of dividends. Capital gains are not taken into consideration in the dividend growth model. This is a faulty assumption, because it ignores the reality that some investors do invest for capital gains. Dividend growth model proponents argue that people invest in firms that do not pay dividends for the expectation of future dividends, but many firms have stated an intention not to pay dividends, yet still their shares have a high value. Real world applicability is the major downside to the dividend growth model. For some firms, however, this model can be quite accurate. Mature, dividend-paying firms are good candidates for the use of the dividend growth model. One benefit of this model, however, is the ease of use. The dividend growth model uses only information that is widely available in its calculations, and as with CAPM the math is easy. This lends appeal to the model, despite its other shortcomings.
Arbitrage pricing theory is based on the mathematical principles of the capital asset pricing model. The APT is a superior model because it makes the fundamental nature of risk explicit. It does this by using correlations between macroeconomic indicators and stock price. Whereas CAPM uses the performance of a market index, APT uses a basket of economic variables, each given a weighting by the person doing the analysis. As a result, APT is in theory the most accurate of these models. It is also flexible, because…
