Chapter 8

Valuing Individual Equities: The CAPM
Our book discussion of the fundamental value focused on applying the dividenddiscount model to the pricing of individual stocks to the valuation of the stock market as a whole. That is, we examined how to evaluate the appropriate level for a valueweighted measure such as the Standard and Poor’s 500 composite index or the Wilshire 5000. At one point in the discussion, we noted that the expected return on a portfolio that is composed of such an index, what we will call the market portfolio, is equal to the risk-free interest rate (rf) plus risk premium (rp). (See page 190 of Chapter 8.) To make things slightly easier, we will labels this expected return on the market portfolio rm =rf+rp. So far, we haven’t said anything about the valuation of individual stocks. But with a firm understanding of the expected return on the market portfolio, rm, this is a straightforward problem. To see how to do it, first recall from Chapter 5 that the definition of risk tells us to evaluate the possible payoffs relative to a benchmark. (See page 91.) For an individual stock the benchmark must be the market as a whole, so the question then is how volatile is the return relative to the market. The risk associated with holding an individual stock will be higher than the risk of holding the market as a whole. The reason for this is that the market portfolio is diversified, as the various stocks in the market do not rise and fall in value simultaneously. Recall that diversification reduces risk. The more volatile the return on an individual stock is relative to the market, the higher the risk and the higher the return. This means that enticing investors to hold individual stocks will require offering them returns in excess of the market. This is a description of the Capital Asset Pricing Model, or CAPM. The CAPM is a simple method that is