CAPM: An Absurd Model
17 Pages Posted: 7 Oct 2014 Last revised: 18 Oct 2017
Date Written: November 19, 2015
The CAPM is about expected return. If you find a formula for expected returns that works well in the real markets, would you publish it? Before or after becoming a billionaire?
The CAPM is an absurd model because its assumptions and its predictions/conclusions have no basis in the real world. The use of CAPM is also a source of litigation: many professors, lawyers…get nice fees because many professionals use CAPM instead of common sense to calculate the required return to equity. Users of the CAPM make many illogical errors valuing companies, accepting/rejecting investment projects, evaluating fund performance, pricing goods and services in regulated markets, calculating value creation...
It is important to differentiate between a fact (something that truly exists or happens: something that has actual existence; a true piece of information) and an opinion (what someone thinks about a particular thing).
We all should try to explain a portion of “the world as it is”, not of “the world according to a wrong theory”. Ricardo Yepes, professor of philosophy of my university, wrote: “Learning means being able to keep perceiving reality as it truly is: complex - and not trying to fit every new experience into a closed and pre-conceived notion or overall scheme”. We may find out an investor’s expected return for IBM by asking him. However, it is impossible to determine the expected return for IBM of the market, because this parameter does not exist. Different investors have different cash flow expectations and different expected (and required) returns to equity. One could only talk of the expected return of the market if all investors had the same expectations. But investors do not have homogeneous expectations.
Valuation is about required return. But there are persons, papers and books that mix (or assume that are equal) expected and required returns.
Sections 11 and 12 show how to calculate required returns in a sensible way and how to use betas being a reasonable person.
Keywords: CAPM; Expected beta; historical beta; required beta; Expected Market Risk Premium; Required Market Risk Premium; Expected Return to Equity; Required Return to Equity; Company Valuation
JEL Classification: G12, G31, G32
Suggested Citation: Suggested Citation