CAPM

What it means

The CAPM, capital asset pricing model, determines the return an investor should require from an investment given its risk. The required return equals the risk-free rate plus the beta coefficient times the market risk premium.

The model assumes investors are rewarded only for risk they cannot diversify away, the systematic risk measured by beta. Risks specific to one company should be spread across a portfolio.

The CAPM is the most widely used way to estimate the cost of equity that feeds into the WACC. Despite criticism it remains the standard in business valuation and investment appraisal.

How it works in practice

When valuing a Slovak company, the CAPM is usually extended with premiums for country risk, small size and specific risks such as dependence on the owner. The resulting cost of equity for small companies tends to be high.

With a risk-free rate of 3 %, a beta of 1.1 and a market premium of 5 %, the CAPM gives 8.5 %. Adding size and specific risk premiums can push the figure for a small company above 12 to 15 %.

An expert valuation must justify each input and cite sources. A one percentage point difference in the cost of capital can change the value of long-term cash flows by tens of percent.

What to watch out for

The CAPM rests on simplifying assumptions such as efficient markets and rational investors. For small private companies its inputs are hard to estimate, so the result should be cross-checked with other methods.

A common mistake is to combine inputs from different sources that do not fit together, such as a US premium with a euro risk-free rate. Consistency of inputs matters more than the precision of any single number.