Time Value of Money
Annuities
Perpetuities
Kinds of Interest Rates
Future Value of an Uneven Cash flow
Probability Distribution
Standard Deviation
CAPM
Security Market Line
Bond Valuation
Stock Valuation
Cost of Capital
The Balance Sheet
Capital Budgeting
Financial Terms
Financial Charts
Fuel Mileage
Energy Efficiency
Espanol
Portuguese
Disclaimer
TeachMeFinance.com
CAPM - The Capital Asset Pricing Model
Beta -
Now, you gotta know about Beta. Beta is the overall risk
in investing in a large market, like the New York Stock
Exchange. Beta, by definition equals 1.0000. 1 exactly.
Each company also has a beta. You can find a company's
beta at the Yahoo!! Stock quote page. A company's beta is that company's risk
compared to the risk of the overall market. If the
company has a beta of 3.0, then it is said to be 3 times
more risky than the overall market.
| Ks = Krf + B ( Km - Krf) |
- Ks = The Required Rate of Return, (or just the rate of return).
- Krf = The Risk Free Rate (the rate of return on a "risk free investment", like U.S. Government Treasury Bonds - Read our Disclaimer)
- B = Beta (see above)
- Km = The expected return on the overall stock market. (You have to guess what rate of return you think the overall stock market will produce.)
As an example, let's assume that the risk free rate is 5%, and
the overall stock market will produce a rate of return
of 12.5% next year. You see that XYZ company (Read our Disclaimer) has a beta of 1.7.
What rate of return should you get from this company in order to be rewarded for the risk you are taking? Remember investing in XYZ company (beta =1.7) is more risky than investing in the overall stock market (beta = 1.0). So you want to get more than 12.5%, right?
- Ks = Krf + B ( Km - Krf)
- Ks = 5% + 1.7 ( 12.5% - 5%)
- Ks = 5% + 1.7 ( 7.5%)
- Ks = 5% + 12.75%
- Ks = 17.75%
So, if you invest in XYZ Company, you should get at least 17.75% return from your investment. If you don't think that XYZ Company will produce those kinds of returns for you, then you would probably consider investing in a different stock