Stock Valuation Methods: CAPM, DDM, and Book Value Analysis

Stock Return and Standard Deviation Analysis

The average stock return for Corporation A was 12% during the three-year period from 2011 to 2013. The corporation saw mixed results during this time, as the stock price increased 16% in 2011 compared to just 8.2% in 2012. The stock price may not fully reflect actual corporate performance during this period. From 2011 to 2012, the company recognized a near doubling of its net income, and was also able to keep expenses associated with interest and salaries down. The lower stock price appreciation may indicate that the market was already anticipating a large increase in net income, or the company may have fallen out of favor with investors.

The standard deviation between each period is roughly 4%, which is around 30% of the average return for the stock. This is reasonable given the short time horizon being examined. Because only three years are analyzed, it is quite possible that market turbulence influenced stock performance irrespective of overall business performance. This can occur when macroeconomic factors heavily overwhelm the decision-making processes of the investing public. Instead of reviewing underlying business fundamentals, investors during this three-year period may have placed excessive weight on macroeconomic factors, adversely impacting the stock price and contributing to a higher standard deviation. If the standard deviation were observed over a longer time horizon of 10 to 20 years, the overall magnitude would likely have been much lower.

The coefficient of variation is calculated as the population standard deviation divided by the population mean.

CAPM: Formula, Assumptions, and Limitations

The figures used in the following example are not fully indicative of current economic reality. The ten-year Treasury yield, for example, recently crossed 2% after nearly a decade of yields between 1.5% and 1.8%. This is notable given that investors are willing to lend money for a decade at a rate below the Federal Reserve's publicly stated inflation mandate of 2%. On a real basis, investors are essentially guaranteed to lose purchasing power over their investing time horizon. Recent Federal Reserve minutes have indicated a faster pace of rate increases, but the impact on the Capital Asset Pricing Model (CAPM) remains uncertain.

When reviewing the CAPM equation, most variables are known. The risk-free rate, according to the case, is 8% — a figure that would be considered extraordinarily high in today's environment. The beta is 1.5, indicating above-average volatility relative to the market. In reality, beta does not measure risk in the traditional sense; rather, it measures volatility, which is a distinct concept. On many occasions, professors, academicians, and institutional investors lose sight of this distinction. Beta, although mathematically sophisticated, is not especially useful for measuring the true risk of an investment. The real risk of an investment is the propensity for permanent capital loss — a concept that is difficult to quantify and therefore does not lend itself easily to typical corporate finance frameworks. As a result, practitioners often default to beta, which does not capture the fundamental downside risk faced by investors.

For the purposes of CAPM, the equity risk premium is defined as the overall equity return of an index above the risk-free rate. In this case, the risk-free rate is 8% and the overall market return over the three-year period is approximately 15%, yielding an equity risk premium of roughly 7%. However, using the values provided in the case, the equity risk premium calculates to approximately 5%. Applying these values to the CAPM formula:

R = Rf + Beta × (Equity Risk Premium)

We arrive at a figure of roughly 15.5%. The term "roughly" is used deliberately, as finance involves a degree of judgment and estimation. The profession often presents what are ultimately educated guesses as precise science — a characterization that does a disservice to more empirically rigorous disciplines. This broader critique is beyond the scope of this report, but it is worth acknowledging in the context of the Capital Asset Pricing Model.

Dividend Calculation and Payout Analysis

The dollar amount of dividends declared in 2013 was $1.21. The earnings per share for the business in 2013 were $6.71, and the dividend payout ratio was 18%. Multiplying earnings per share by the payout ratio yields the dividend per share of $1.21.

Earnings Per Share: $6.71 | Dividend Payout Percentage: 18% | Dividends Per Share: $1.21