CAPM Model

The Capital Asset Pricing Model (CAPM) is a financial model that describes the relationship between risk and expected return. It is commonly used to estimate the required rate of return for an investment, such as a stock or a portfolio of stocks.

The CAPM formula is:

Expected Return = Risk-Free Rate + Beta x (Market Return – Risk-Free Rate)

Where:

Risk-Free Rate is the theoretical rate of return of an investment with no risk, such as a government bond.

Beta is a measure of the systematic risk of an investment. It indicates how much a stock’s price is likely to move compared to the overall market. Beta of 1 indicates the stock moves in line with the market, while beta greater than 1 suggests higher volatility.

Market Return is the expected return of the market as a whole, such as the return of a stock market index.

The CAPM model assumes that investors require compensation for two types of risk: systematic risk, which cannot be diversified away, and unsystematic risk, which can be reduced through diversification. The CAPM model only focuses on the systematic risk component, which is measured by beta.

Investors use the CAPM model to determine the required rate of return for an investment based on its beta and the expected return of the overall market. If the expected return of the investment is higher than its required rate of return, it may be considered a good investment.

While the CAPM model is widely used in finance, it has some limitations. For example, it assumes that investors have access to the same information and have identical expectations about the future, which may not be realistic in practice. Additionally, the model relies on historical data to estimate future returns, which may not always be a reliable predictor of future performance.

Cash Flow Based Model

The cash flow based model is a method of valuing a company based on its expected future cash flows. It is a commonly used valuation method that focuses on the ability of a company to generate cash in the future.

The basic formula for the cash flow based model is:

Company value = Present value of expected future cash flows

This formula involves projecting the future cash flows of the company over a certain period of time, usually five to ten years, and then discounting them to their present value using a discount rate. The discount rate is typically based on the company’s cost of capital, which reflects the risk associated with the company’s operations.

The cash flow based model takes into account the timing and amount of expected cash flows, as well as the risk associated with those cash flows. It is a useful tool for valuing companies that generate consistent cash flows over time, such as mature companies in stable industries.

One advantage of the cash flow based model is that it focuses on the ability of a company to generate cash, which is ultimately what drives the value of the business. It also allows for flexibility in the projection of future cash flows and the discount rate used to calculate present value.

However, the cash flow based model has some limitations, including the difficulty of accurately predicting future cash flows and the discount rate, which can be subjective and vary depending on the assumptions used. As with any valuation method, it is important to use multiple methods and to consider a range of factors when determining the value of a company.