I will be submitting a detailed assessment of the three models Capital Asset Pricing Model (CAPM), Arbitrage Pricing Theory (APT), and The dividend Growth Model. By analyzing all three models and making a clear stance and determination which of the three would be the best conclusion for the Google Inc.
I examined each of the applications as well as their respective ease of use. The Capital Asset Pricing Model is a single factor model that establishes a relationship between risks and required, expected returns of an investment in an asset. This concept is based on the general idea that investors demand higher returns for bearing riskier investments (Downes & Goodman, 2003). The Arbitrage Pricing Theory is an alternative to the Capital Asset Pricing Model. The APT is a multi-factor model that is based on the measurement of the volatility of multiple risk factors common to the market (Downes & Goodman, 2003). The Dividend Growth Model is an approach that assumes dividends grow at a constant rate in perpetuity. The value of the stock equals next year’s dividends divided by the difference between the required rate of return and the assumed constant growth rate in dividends. The basic assumption in the Dividend Growth Model is that the dividend is expected to grow at a constant rate and that this growth rate will not change for the duration of the evaluated period (http://financial-dictionary.thefreedictionary.com).
All three concepts have the same general purpose as for measuring the risk and required return for an asset, but achieve this goal through different means. CAPM is a single factor model in which risk measurement is concerned primarily with an asset’s volatility in relation to the general market, while APT is a multi-factor model where risk measurement is based on an asset’s volatility in relation to a various number of common market factors. CAPM is a more simplified, general approach to how an asset has historically moved in relation to the general market, while APT is a more difficult, complex concept laden with estimation errors, uncertainty, and possibly distracting factors. In this report I will discuss the Capital Asset Pricing Model, the Arbitrage Pricing Theory as well as the Dividend Growth Model and I will explain why I believe CAPM is a better approach than either of the other two for your company to use when measuring risk and required returns.
Here is the three models in detail;
Dividend Growth Model
In this approach it is assumed that dividends grow at a constant rate in perpetuity. The Dividend Growth Model is better suited for those stable companies that fit the model. Those that are growing quickly or that don’t pay dividends do not fit the assumption parameters, and thus this model cannot be used. In this model, a company may not exceed the market growth rate.
In addition, since the dividend growth rate is expected to remain constant indefinitely, the other measures of performance within the company are also expected to maintain the same growth rate. If in the current state, the dividend rate is greater that earnings, in time this model will show a dividend payout greater than the earnings of the company. Conversely, if earnings are growing faster than dividends, the payout rate will converge towards zero.
Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a better approach for financial professionals to use than the Arbitrage Pricing Theory (APT) when measuring the risk and required return for assets. The Capital Asset Pricing Model is a single factor model that establishes a relationship between risk and required/expected returns of an investment in an asset. This concept is rooted in the general idea that investors demand higher returns for bearing riskier investments (Downes & Goodman, 2003). The CAPM is a single factor model in the sense that a single variable, the beta, is the foundation for all the differences in returns for all securities (Smart, Megginson, & Gitman, 2007).
The beta is the measure of how stocks move and its relationship to the market as a whole. It is essentially a measure of systematic risk that affects the market as a whole and cannot be neutralized by diversification. Assuming that the market as a whole moves at a beta measurement of 1, then a beta of higher than one would indicate that an asset moves more drastically than the market in general, while a beta of lower than one implicates that an asset moves less drastically than the market as a whole. The beta is the single factor in the CAPM equation that denotes differences throughout all securities.
The CAPM equation used to measure the risk and required return of an asset centers around three inputs. These inputs are the risk free rate, the expected market return rate, and an asset’s beta. By using these three pieces of information we can assume that the required rate of return to accept the risk on an asset equals the sum of the risk free rate and an asset’s beta multiplied by the risk premium, which is the difference between the expected market return rate and risk free rate. As long as we have this information we can calculate the required rate of return for accepting the certain level of risk associated with an individual asset (Hamm, 2006). An asset’s beta is the only true variable in this equation as the risk free rate and expected market return rate will stay constant among the different assets with varying betas. Utilizing an asset’s beta, the risk free rate, and the expected market return rate, the CAPM equation can be a very useful tool in evaluating an assets risk and reward element in relation to the rest of the market as a whole.
The CAPM equation and its ability to give a reasonable calculation about the required rate of return for accepting particular levels of risk in the market are enabled under a number of assumptions. A few of these assumptions are that all investors are generally risk averse and do require a higher level of returns for riskier investments, that diversifiable or unsystematic risk can be neutralized through diversification and that as a result investors are only concerned with the systematic risk of an investment, that the market offers no reward for unsystematic risk, and that all investors possess homogeneous expectations (Smart, Megginson, & Gitman, 2007). Many of the assumptions associated with CAPM are not entirely realistic and exist in the most part to simplify this model for decision making (The CAPM and APT).
The general purpose of the CAPM is to give investors a reasonable estimate of a required rate of return that would be needed on an asset in order to accept its level of risk. Assuming that unsystematic risk has been or can be diversified in a portfolio, CAPM is primarily concerned with the affect of systematic risk or general market risk on an asset. Using its historical volatility in correlation to market movement as an indicator as well as the risk free rate and expected market return rate, this model gives investors a general idea as to the risk and reward associated with a particular asset. Even though it is simple in nature, this model can be a very powerful and useful tool in investment decision making. An alternative to the Capital Asset Pricing Model is the Arbitrage Pricing Theory.
Arbitrage Pricing Theory
Unlike CAPM, APT is founded in the idea that the risk and return of an asset are affected by a group of different market factors (Smart, Megginson & Gitman, 2007). As opposed to the CAPM, where the systematic risk of the market as a whole is applied to assets, the APT segregates the total systematic risk into smaller components of market risk. APT does not specify, identify, or give any guidance as to what these factors are or how many exist (The Economist, 1991). These different risk factors signify different types of systematic risk that cannot be neutralized by diversification. All assets are affected by each individual market factor and its own individual factor beta (Smart, Megginson & Gitman, 2007).
The APT attempts to break many of the basic assumptions of the CAPM. This theory establishes the idea that different assets will have a varying level of sensitivity to these smaller, common market risk factors. The theory also asserts that investors have varying levels of risk tolerance and need to structure portfolio selection and portfolio risk management to their own specific goals (Otuteye, 1998). This is a more advanced concept than the CAPM, but still presents an issue in regards to the unknown set of smaller risk factors that constitute the systematic risk.
The complexity of this theory in addition to a random amount of unknown factors is where we begin to see problems with this concept. No one knows the exact factors that constitute the systematic risk of the market that have a significant movement affect on assets, affecting their risk and return (Otuteye, 1998). The volatility of assets in relation to the different risk factors may have either a relevant and useful affect or misleading influence. APT allows for multiple sources of risk within the systematic risk realm that affect an asset’s market sensitivities. Neither professionals nor academics can come to an agreement on the number or identity of these different risk factors. The more risk factors that an investor includes in risk and return evaluation of an asset, the more misleading noise they may have to endure (The CAPM and APT). The inability to accurately identify correct sets risk factors or even predict their behavior can significantly impact estimates and expectations as well as severely hinder investment evaluation and decision making.
APT could be a very useful tool in theory. It is a much more advanced concept than CAPM. However, the current APT contains many errors in association with the many different risk factors, especially as a result of the unknown number and identity of the various, common risk factors. The APT is certainly more complex and difficult to use than the CAPM. APT’s main issue is that of theory versus practicality (The CAPM and APT). In theory, this could be a great tool in determining the varying degree of sensitivity and risk associated with different assets in the market as a result of the varying factors of systematic risk. In practice, our inability to accurately identify the number or type of risk factors affect the sensitivity of assets make this a difficult, complex, and inconclusive model to follow.
Regarding the ease of use of the three models, I will submit the following analysis. There are a number of reasons why CAPM is the better approach than APT and the Dividend Growth Model for our company to use when evaluating the risk and return of an investment. CAPM is a very simple yet powerful and useful tool in evaluating the risk and return acceptable in decisions about investments. It uses historical volatility in correlation to the market movement in order to provide a reasonable indication of required or expected returns for varying levels of risk associated with different assets. Also, many of these reasons are a result of the difficulties associated with APT. Some of the difficulties and problems that arise with APT are estimation error, uncertainty of varying risk factors among assets, risk factors change over time, timing differences among factors, and its complexity.
Estimation and expectation errors occur with APT as a result of the issue pertaining to the unknown number or identity of risk factors (The CAPM and APT). It is difficult for any multi-factor model to not have a clear set of influential parameters for analysis and evaluation. “This can make the model difficult to understand and increase the role of misleading “noise” that can significantly distort any results” (eMasterTrade, APT).
The uncertainty of varying risk factors among assets can also create a problem when using the APT. The behavior of every individual asset is different. As a result of this, every individual asset will have its own composite of risk factors that will affect its volatility. This situation makes it difficult to match or use “sets” of factors among assets. The composition and makeup of these sets of risk factors will also change over time. This means that APT’s model will only be relevant for an undisclosed period of time and must be continually rebuilt as necessary. Many of the risk factors that affect an asset may change. This relates to another problem with this the model of APT and varying risk factors. Risk factors are not predictable and do not exist on a schedule. Different risk factors will affect the sensitivity of an asset at different times that are not determinable. “This can create another issue with the estimation or expectation of risk and return on an asset” (eMasterTrade, APT).
Overall, APT is far too complex, involving too many parameters and risk factors that cannot be properly identified or predicted. This is a concept that is great in theory, but cannot practically be applied in a predictable, reasonable, or accurate manner. CAPM on the other hand utilizes a simple model based on indicating historical volatility in relation to the movement of the entire economy and market. The CAPM is easier model to use and understand. As a result of the differences inherent in these two models, the CAPM model can give us more reasonable estimates of the required rate of return acceptable in relation to the level of risk associated with an asset. Regarding the Dividend Growth Model it is quite an appealing approach to certain companies, but The Dividend Growth Model approach to estimating the cost of equity has some appeal to management as it directly links the strategic plans, goals, and objectives to the cost of capital, and it is simple to calculate. However, if a company does not pay a dividend or it has an erratic or uncertain growth rate, the dividend growth model cannot be used (Finance and Accounting for the Nonfinancial Managers, J.Fred Watson, pg 285). This makes this model a little less desirable and I would opt for the certainty of the CAPM over it for our company.
In summary, I would recommend the Capital Asset Pricing Model due to it is a much simpler and straightforward approach to calculating the risk and required return associated with an asset than the Arbitrage Pricing Theory and the Dividend Growth Model. The Arbitrage Pricing Theory is much more complex, while containing unknown variables which it behavior and affect cannot truly be measured, while the Dividend Growth Model works well for those companies growing at a rate equal to or lower than that of the economy and have an established and stable dividend payout. Although it is conceptually more advanced than the Capital Asset Pricing Model, the Arbitrage Pricing Theory is inherent with potential disadvantages. These potential disadvantages, in addition to the more reasonably accurate evaluative and analytical ability of its alternative, the Capital Asset Pricing Model, make CAPM the best approach for Google to use when calculating the risk required and expected return of possible investments.
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