CAPM - An example for stock investing

In the last article I introduced the CAPM as a stock investing decision tool.
This time I want to apply this to a certain example.

However, before beginning with it, I want to make the equation of the CAPM clearer.
Here it is again:

E(Ri) = Rz + [E(Rm) – Rz]Bi

Can you remember the math lessons in high school?
You have definitely heard something about linear equations of the type:

y = 3x + 4

The CAPM-equation is exactly the same. The linear equation here in the example begins at 4, the CAPM at Rz. The gradient is 3 and the gradient of the CAPM is E(Rm)-Rz. The resulting linear line is called the security market line.

The recommended decision of the CAPM is this:
Buy those stocks which have an expected return above the return the CAPM calculated for this certain stock.

It must be more precise thus, you get an example now:

Stock a
E(a) : 20% (expected return per year)
Beta(a) : 1,3

Stock B
E(b): 15%
Beta(b): 0.8

Stock C
E(c): 22%
Beta(c): 2,5

The expected market portfolio should be E(Rm) = 12%
The riskless security Rz = 3%

Using these information with the CAPM brings these results about:

E(a) = 3% + (12%-3%)1,3
= 3% + 9*1,3
= 14,7%

This means for stock a: The real market value of stock a is 14,7%, but 20% are expected, thus stock a is a definite “buy”.

E(b) = 10,2%
15% are expected, so stock b is also a “buy”.

E(c) = 25%
But only 22% are expected, thus stock c is not a “buy”, it is a “sell”.

If you don’t have any expected information about stocks, you can also compute how much return a certain stock must bring in when the expected return of the market portfolio and the beta of the stock you are focusing on are known.

Stock D

Beta = 2,3

E(d) = 23,7% can be expected.

Ok, I hope you know what the CAPM is trying to teach us and how to apply it. It’s in principle very simple. Yes, but is it also practicable concerning real stock investing?

This question will be discussed in the next issue.

Stock Investing