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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.
