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If you can estimate an asset s beta and the market s risk premium, you can estimate the expected return for a particular stock. You can find betas for different stocks on Yahoo Finance and numerous other financial Web sites. (We discuss beta and the market risk premium in 6.) As an example, let s look at the expected return for Microsoft. We use a risk-free rate of 4 percent and an expected return on the stock market of 7 percent. If we go to the Yahoo Finance Web site on the Internet and type in the symbol MSFT for Microsoft, we find a beta estimate of 1.4. When we plug these numbers into the CAPM equation, we get: E(msft) 4% 1.4[ 7% 4%] 4% 4.2% 8.2%
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This means that Microsoft s common stock is expected to generate a return of 8.2 percent this year.
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CAPM is the granddaddy of asset pricing models. It has been around since the mid-1960s, and provides an estimate of the return that the market requires for investing in risky stock. The CAPM has been the subject of hundreds of academic tests, most of which have found that it works reasonably well. Some academics have suggested that other models, such as an arbitrage pricing model and a multifactor asset pricing model, work better. But, the observed performance of these models does not seem to justify their added complexities. We use the cost of equity capital calculated by the Capital Asset Pricing Model as an input for our discounted cash flow stock valuation model. It is a very simple yet powerful way to estimate the cost of equity, which is usually the most significant component of a company s weighted cost of capital. Recall that the value of an investment is equal to the expected cash flows of the investment, discounted to the present at a rate that reflects the risk and the timing of the expected cash flows. We believe that CAPM is the best way to estimate the discount rate associated with a risky common stock, and we recommend that you use it as well.
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A trade-off exists between higher expected return on an investment and greater risk. Safe investments have low returns. High returns re-
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quire investors to take big risks. Most investors do not understand risk, the trade-off between risk and return, or the tendency for stock returns to revert to their average levels, a concept known as reversion to the mean. It s important to understand these concepts, and to recognize when a stock s price becomes too high for the operations of the company to support. When that situation occurs, it is overvalued sell the stock! The Fama and French study shows that investors can consistently make money by buying stocks with high book-value-to-market-value ratios value stocks, and by selling stocks with low book-value-to-market-value ratios growth stocks. This is the type of investment strategy that we follow in the book. To a risk-averse investor, the pain of losing a dollar outweighs the pleasure of winning a dollar. Be sure that you understand the risks involved in the asset in which you are investing. If the odds aren t in your favor or the return isn t sufficient to compensate for the risk, take a pass and find an investment with more favorable risk/return characteristics. Current stock price indicates the amount that the marginal investor, given supply and demand considerations, is willing to pay to acquire a share of that particular stock. In the short run, price may or may not have anything to do with the true long-term value of a company. Over time, price and value should align. Don t be afraid to sell on the first piece of bad news that doesn t pass your smell test. Be skeptical when you see investment professionals tout their historical performance. Remember Martha s investment performance. The simple average of her returns was 10 percent per year versus the compound average return of 36.75 percent, which showed what really happened to her portfolio. Cut all transactions costs to the lowest level possible! Establish tax advantaged retirement accounts and fund them to the maximum that the law and your income allow. If you are serious about investing, you should understand how to value stocks and bonds. To do this properly, you need to know the basics regarding the time value of money the math underlying compounding and discounting. The math is not difficult but does require you to understand the relationship between present and future values, how to use exponents, and how to compound to future value and discount to present value.
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