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CAPM vs APT vs Dividend Discount Model: Cost of Equity

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Abstract

This paper evaluates three models used to estimate a firm's cost of equity capital: the Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), and the Dividend Discount Model (DDM). It argues that CAPM is the most practical choice due to its consistent formulation, widespread availability of inputs such as beta, and reasonable assumptions. The DDM is rejected for relying on unrealistic dividend-based assumptions, while APT, though more accurate and flexible, is deemed too arbitrary and difficult to apply consistently. The paper concludes with a comparative application of CAPM to Nike, Sony, and McDonald's, demonstrating how beta drives differences in the cost of equity across firms.

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What makes this paper effective

The paper uses a clear elimination structure — ruling out the DDM first, then comparing APT and CAPM — which makes the argument easy to follow and logically airtight.
It grounds abstract financial theory in a concrete numerical example, applying CAPM to three real companies (Nike, Sony, McDonald's) to validate its earlier reasoning about beta and risk.
The critique of the dividend discount model is pointed and specific, identifying the flaw that many companies neither pay nor intend to pay dividends, rather than offering a vague dismissal.

Key academic technique demonstrated

The paper demonstrates comparative evaluation: rather than describing each model in isolation, it assesses each against practical criteria — ease of use, consistency of formulation, and realism of assumptions — before reaching a justified conclusion. This technique is essential in finance and business writing where multiple frameworks exist and practitioners must choose among them.

Structure breakdown

The paper is divided into two parts. Part I (three paragraphs) introduces all three models, critiques the DDM, and argues for CAPM over APT. Part II applies CAPM numerically to three companies, confirming that beta is the primary driver of variation in the cost of equity. The structure moves from theory to application in a logical sequence.

Introduction to Cost of Capital Models

There are three different models for estimating the cost of capital: the Capital Asset Pricing Model (CAPM), the Dividend Discount Model (DDM), and Arbitrage Pricing Theory (APT). Of these, CAPM is the best model. CAPM utilizes the returns on a company's stock to calculate the firm's cost of equity. The underlying theory is that the firm's cost of capital should "equal the rate on a risk-free security plus a risk premium" (Investopedia, 2012). The risk premium is related to the return on the company's stock.

Arbitrage Pricing Theory is similar to CAPM, using the same basic formula, but instead of equating risk with the market return on the company's stock versus the broad market index, the return on the company's stock is compared against a basket of macroeconomic indicators (Pietersz, 2011). These indicators are chosen by the user, and the correlations as well as the weightings of the different indicators must also be calculated and selected by the user. This contrasts with CAPM, which uses beta — a correlation statistic that is widely available online. This makes CAPM much easier to use, even if APT is arguably more accurate. APT is, however, more arbitrary, whereas CAPM's formulation is consistent across companies.

The Dividend Discount Model derives the cost of equity in an entirely different manner. It is based on the idea that the cost of equity is related to the implied risk premium of the stock, but derives that risk premium from the premise that stock prices reflect current and expected dividends. Under this model, the discount rate is what remains after the stock price, current dividend, and dividend growth rate are taken into account — any stock price above the implied value of the current dividend and dividend growth rate must be attributed to the risk premium.

The Dividend Discount Model and Its Limitations

The major flaw in the Dividend Discount Model is that it simply does not reflect how investors think. Many investors do not price stocks solely on the intrinsic value of dividends, and many companies do not even pay dividends. The latter point is sometimes argued away by stating that dividends are expected in the future — but this is a hollow argument, as many companies have no intention of paying dividends at any point, which calls into question the viability of the model for those firms.

With the Dividend Discount Model excluded for its unrealistic assumptions, we are left with APT and CAPM as the primary means of determining the cost of equity. APT has the benefits of being more accurate and more flexible, but it is much harder to work with. CAPM is relatively accurate, rests on sound fundamental assumptions, and — perhaps just as importantly — is easy to apply, making it the best choice for determining a company's cost of equity.

2 Locked Sections · 215 words remaining

CAPM vs. APT: Choosing the Best Model · 75 words

"CAPM favored over APT for consistency and ease"

Applying CAPM: Nike, Sony, and McDonald's · 140 words

"CAPM applied to three companies using beta"

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Key Concepts in This Paper

CAPM Cost of Equity Beta Risk Premium Arbitrage Pricing Theory Dividend Discount Model Firm-Specific Risk Market Return Equity Models Cost of Capital