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speedybure (< 20)

THE VAST SHORTCOMINGS OF THE CAPITAL ASSET PRICING MODEL & ALTERNATIVES

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May 20, 2009 – Comments (5)

The Capital Asset Pricing Model is as precise at estimating risk as Moody's was for assesing sub-prime risk. There are several superior methods to determine risk for any given equity. But first let;s break down CAPM and expose the numerous shortcomings.

1) CAPM = Rf + B(Rp)

There is no such thing as "risk free" for 2 reasons: Inflation (especially the rampant rates in our near future) destroy the purchasing power of both a 10-year treasury as well as the interest earned. Even using a inflation protected yield distorts reality. It is determined using the Consumers Price Index which is an arbitrary basekt of goods that has been manipulated numerous time to downplay inflation (a great example was April's CPI (0%), if calculated as it was in 1980 would have been in excess of 6%. The risk free rate doesn'r exist in reality, rather only in text books. This, however, is a very small problem of this model.

 

BETA is bane of my investing existence! BETA is the volotaility of an given equity measured against one of the major benchmarks. This should only really be done using the Wilshire 5000 as to incorporate as much of the market as possible. But then the next problem presents itself: For example, if i run a regression for miscorsoft against this index, don't you have to exclude microsoft from the Wilshire before it is run? In other words you would be running a regression of microsoft against itself to a certain degree, thus skewing the R-square. Aside from that point, why is volotility a measure that when increased, also increased implied risk. The sheer fact an given equity flucutates widly, allows one to dollar cost average their way into a position on larger scales and could very likely reduce the average purchase price. One last note on Beta: it is a historic number, and last time i checked markets were extremely dynamic, not static as this would imply. 

SO WHATS ARE SOME ALTERNATIVES?  I personally begin with basic financial ration i.e current, quick, time interest earned, operating cash flow to liabilities, free cash flow % of net income, etc. A largely ignored but excellent measure is ALTMAN-Z (which has a great track record for detecting companies that would go bankrupt) and other alternatives to this model. Another model is the Beneish Model with calculates the proobability of accounting manipulation ( and like the Z-score, has a rather good track record). You should also incorporate your personal required rate of return as opposed to risk free. This is just one example of an alternative to the inherently flawed CAPM, which as I mentioned before is not practical in the real world. 

5 Comments – Post Your Own

#1) On May 20, 2009 at 3:58 PM, DaretothREdux (43.57) wrote:

Sounds like the models that work are the ones that bet on failure.

I think a butterfly just flapped its wings...watch out China.

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#2) On May 20, 2009 at 4:32 PM, speedybure (< 20) wrote:

I'm just pointing out mainstream valuation techniques and how they are severly flawed, if you ran the alternatives i mentioned on any bank over the last 5 years, they would  have indicated a high probability of bankrutpsy, thus risk

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#3) On May 20, 2009 at 5:17 PM, finabuddy (96.34) wrote:

I was preparing a longer response (given my job is use the valuation methods), but I suppose your follow up post made me decide not to  -So, i will keep it short.

 I agree that there are flaws in valution methodology - but these are acceptable and what is used to get M&A deals done. I did cringe a couple times with your run down of risk free and beta (which I would love to discuss). However, let's be clear here- you are talking about solvency, bankruptcy, CREDIT/LEVERAGE statistics (outside of working capital, not really the same animal here). Valuation is risk related, but totally different in methodology. DCF, m&a comps, trading comps, are all very useful for valuation. You are right though if looking for risk of default, bankruptcy, etc. - you have to analyze credit and leverage related statistics as you cited.

 Give our industry a little more credit - healthy m&a guys care about valuation and equity/debt contribution, among others. Restructuring groups care about the things you mentioned (FCF/interest, debt load, debt covenants).

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#4) On May 20, 2009 at 5:20 PM, finabuddy (96.34) wrote:

and finally, let me add restructing groups ALSO use those valuation methods in their advisory work. Distressed companies might have the option of a sale too.

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#5) On May 20, 2009 at 7:55 PM, speedybure (< 20) wrote:

liquidity, solvency & ability to cove debt covenents/ earn enough profit to keep operations going are an important measure of risk. lets just say company A has an interest coverage ratio of 2 compared to company B which has a TIE of 15, the latter should have a lesse discount rate (all else equal).

What i was trying to say was that determining a risk measurment for the average investor can be done more accurately in my opinion using Altman-Z and Beneish (although i use one not mentioned) because beta(volotility * risk premium is ridiculous) . In other words a high beta stock has nothing to do with risk i.e they are not neccessarily mutually exclusive.

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