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Musings on Markets's Blog

Alternatives to the CAPM: Part 5. Risk Adjusting the cash flows

August 22, 2011 Comments (0)

In the last four posts, I laid our alternatives to the CAPM beta, but all of them were structured around adjusting the discount rate for risk. Having made this pitch many times in the past, I know that there are some of you who wonder why I don't risk adjust the cash flows instead of risk adjusting the discount rate. The answer to that question, though, depends on what you mean by risk adjusting the cash flows. For the most part, here is what the proponents of this approach seem to mean. They...

Alternatives to the CAPM: Part 4: Market-Implied cost of equity

August 22, 2011 Comments (0)

As you can see from each of the alternatives laid out in the previous three parts, there are assumptions and models underlying each alternative that can make users uncomfortable. So, what if you want to estimate a model-free cost of equity? There is a choice, but it comes with a catch. To see the choice, assume that you have a stock that has an expected annual dividend of $3/share next year, with growth at 4% a year and that the stock trades at $60. Using a very simple dividend discount...

Alternatives to the CAPM: Part 3: Connecting cost of debt to cost of equity

August 22, 2011 Comments (0)

Analysts have generally had an easier time estimating the cost of debt than the cost of equity, for any given firm, for a simple reason. When banks lend money to a firm, the cost of debt is explicit at least at the time of borrowing and takes the form of an interest rate. While it is true that this stated interest rate may not be a good measure of cost of debt later in the loan life, the cost of debt for firms with publicly traded bonds outstanding can be computed as the yield to maturity (an...

Alternatives to the CAPM: Part 2: Proxy Models

August 22, 2011 Comments (0)

The conventional models for risk and return in finance (CAPM, arbitrage pricing model and even multi-factor models) start by making assumptions about how investors behave and how markets work to derive models that measure risk and link those measures to expected returns. While these models have the advantage of a foundation in economic theory, they seem to fall short in explaining differences in returns across investments. The reasons for the failure of these models run the gamut: the...

Alternatives to the CAPM: Part 1: Relative Risk Measures

August 22, 2011 Comments (0)

The Capital Asset Pricing Model (CAPM) is almost fifty years old and it still evokes strong responses, especially from practitioners. In academia, the CAPM lives on primarily in the archives of old journals and most researchers have moved on to newer asset pricing models.  To practitioners, it represents everything that is wrong with financial theory, and beta is the cudgel that is used to beat up academics, no matter what the topic. I have never been shy about arguing the following: a....

Margin of Safety: An alternative risk assessment tool?

August 22, 2011 Comments (0)

I have lost count of the number of times I have been taken to task for not mentioning "margin of safety" in my valuation and investment books. In general, the critique is usually couched thus: "Instead of using beta or some other portfolio theory risk measure, why don't you look at the margin of safety?". While I see the intuitive value of paying heed to the "margin of safety",  I don't see the two as alternative measures of risk. In fact, I think that risk measures in valuation and...

Breach of Trust: Bank Valuation after the banking crisis

August 22, 2011 Comments (0)

Until the banking crisis of 2008, investors had made a Faustian bargain, when it came to valuing and investing in banks. Banks were opaque in their public disclosures and investors often had little information on either the risk of the securities held or the default probabilities of loan portfolios. However, investors were willing to accept this opacity and view banks as "safe" investments for two reasons: Banks were regulated in their risk taking: In effect, we were assuming that bank...

Catastrophe and consequences for value

August 22, 2011 Comments (0)

The airwaves have been inundated with news about natural disasters in Japan and their aftermath. Without minimizing the human impact - the thousands who have lost their lives and belongings - and the dangers of a nuclear meltdown, I want to focus on the impact of catastrophes, natural or man-made, on markets and asset values. While each disaster is different, here are some common themes that emerge after the disaster: a. Our definition of "long time periods" is woefully inadequate: After the...

A tide in the affairs of men...

August 22, 2011 Comments (0)

In my last post, I noted how difficult it is to separate luck from skill in  both investment and corporate finance.  While I remain leery of stock picking success stories (and believe me when I say I hear dozens each week), I continue to admire successful businesses of all stripes, from the bagel shop in my town that manages to sell out every day to Facebook in the social media world. It is not that luck does not play a role in business success. In fact, most successful individuals...

Luck versus skill: How can you tell?

August 22, 2011 Comments (0)

A hedge fund manager doubles her investors' money over the course of a year.. A company's stock increases four fold over the course of six months.... these are not unusual news stories but they give rise to one of those enduring questions in finance: Was it luck or skill? The answer of course is critical. If it was "luck", we should not be giving the hedge fund manager 2% of our wealth and 20% of the profits. If it was skill, the company's managers deserve not just a huge thank you but...