Capital asset pricing model (CAPM)

The capital asset pricing model has been widely used for many years by the global financial services industry to try and predict the returns you should expect from a stock.

If a stock offers a return above that predicted by CAPM you should buy it, and vice versa. The starting point for a stock’s expected return is the minimum ‘risk free’ return an investor should expect from medium-dated AAA government bonds, say 5%. You then add a premium, because stocks in general are riskier than bonds.

This figure is heavily debated, but let’s say it is 3%. Now you adjust that extra premium for a stock’s specific beta, say 1.2. So the expected CAPM return here would be 8.6% (5% + (3% x 1.2)). If you expect the stock you are reviewing to deliver, say, a 10% annual return, then it’s a buy, says CAPM.

• See Tim Bennett’s video tutorial: Warning: the City’s formula for pricing shares is bust.

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