The capital asset pricing model ( CAPM ) is used to determine the required rate of return on a security, it is the cost of equity.  When investing in a security an investor expects a certain return.  This expectation comes from the opportunity cost of putting their money in a certain security as opposed to what it could be earning in a different security.  It also comes from the risk is associated with putting their money in that security.  The CAPM seeks to value that opportunity cost and the risk of the specific security to determine what the required rate of return the investor will have to have to invest their money in this security.  Before we go on, let’s exam the model.

The Capital Asset Pricing Model ( CAPM ) is calculated as follows:

r_a = r_f +β_a( r_m - r_f )

Where:

r_a = required rate of return of the security

r_f = risk-free rate

β_a = beta of the security

r_m = return of the market

Now that we have the formula, let’s pick it apart some more and see why it is put together the way it is as well as find where we can obtain the values for these variables.  The risk-free rate, r_f, is in the equation to signify the opportunity cost of what the money that is invested could be earning.  A United States government bond is usually used to represent the risk-free rate.  A US bond only carries risk if the US government no longer exists, because even if the US government does not have the funds they can print more funds or raise taxes.  There is considered to be a certain premium that needs to be paid for being in the market opposed to a risk-free asset like a US bond.  If there was no greater reward for being in the market, then why would you take the greater risk?  That premium is the return of the market, r_m, subtracted by the risk-free rate, r_f, and is referred to as the equity market premium.  The equity market premium needs to be multiplied by the specific security’s beta, β_a,the statisitcal measure of the security’s volatility in comparison to the market, to see what the premium needs to be for this security.  In other words, the equity market premium multiplied against the security’s beta gives you the amount you need to be compensated in order to assume that amount of risk, a risk premium.  Add that premium to the opportunity you are giving up to invest in, the risk-free rate, and you have your required rate of return on that specific security, r_a.

The capital asset pricing model ( CAPM ), however, is not perfect.  Beta is measuring past prices, and the past is not always an indication of the future.  Beta also does not ecompass all of the valuable information of a security.  There are also different ways to calculate a security’s beta, which can lead to varying required rate of returns of a security .  Smaller capitalization stocks also tended to outperform CAPM evaluations, most likely because they are not accuratley captured in the return of the market, r_m.  However, even for its shortcomings CAPM is very useful to calculate the cost of equity and is widely accepted.  Its creators even received a Nobel Prize for it in the sixties, no alternate method has had any such recognition or acceptance.  But, there is an alternative method for calculating the cost of equity, the dividend capitalization model.  CAPM and the dividend capitalization model are both used for Discounted Cash Flow analysis (DCF).

An ETF is a publicly traded fund that is multiple stocks in a certain sector. Each ETF can be made by a different company. Basically, when you buy an ETF it is easier to manage because you will be owning multiple stocks at a time; it is like a mutual fund. This will help you spread out your risk within a certain sector.

I am sure you are wondering the difference between an ETF and a Mutual Fund… There are a few differences that can really make you want to start using ETF’s instead of Mutual funds. Here are a few of the big differences.

1. ETF’s can be bought and sold at any time
2. ETF’s do not have fees like Mutual funds do

When in a mutual fund, say in one day you went up 10% in the middle of the day and put a sell order in, you can’t sell until the very end of the day. This means you might think you will get 10% profit, but the fund could loose ground and you only make 5% because the ending price. Also, mutual funds have high fee prices. It is like buying each stock in that fund indiviually. Imagine the fees you would have at the end of your buying spree, that is basically how high your fees for mutual funds are. Granted that is not all the cases; ETF’s have the normal trading fee of any stock at your broker.

The weighted average cost of capital, WACC, is a calculation used to determine what the firm is paying in interest on their capital, what is their cost of financing.  Their capital, financing, includes all of their equity, i.e. stock, and debt.  Each piece of capital is weighted against its discount proportionally.  For instance, the interest rate on their debt would be multiplied against the amount of debt that they have (as well as their tax rate) to find the weighted average of the debt side of their capital.

The equation for calculating WACC is as follows:

WACC = (E/V)Re + (D/V)Rd(1-Tc)

Where:

E = market value of the firm’s equity

V = the total capital of the firm, equity + debt (E+D)

Re = the cost of equity

D = market value of the firm’s debt

Rd = the cost of debt

Tc = the corporate tax rate

Finding most of the values for these variables is fairly simple, but a few of them can be a little tricky.  E, the market value of the firm’s equity, will be found on the company’s financial statements, add up all the equity accounts.  (Remember these can usually be found on the company’s website under at term similar to “investor relations” or at google.com/finance or finance.yahoo.com.) D, the market value of the firm’s debt, will also be found on the company’s financial statements, add up their liabilities.  Add E and D together and you will get V, which is the value of the firm’s capital, however, not yet appropriately weighted).  E/V is the percentage of the firm’s financing that is done through equity, and E/D is the percentage of the firm’s financing that is done through debt.  Re, the cost of equity, is more difficult to calculate and requires another model.  The capital asset pricing model ( CAPM ) is the most recognized and popular model for calculating the cost of equity and uses beta, risk free rates, and expected market return to calculate.  Another method is the dividend calculation model which uses current dividends being paid by the company’s stock, the current market value of the stock, and the growth rate of those dividend payments.  Rd, the cost of the firm’s debt, is easier to find as it is the current rate they are paying on their debt and should be disclosed.  A company is able to benefit on their taxes from the interest that they pay so it is important to also multiply their debt by 1 minus their tax rate to get a more appropriate valuation, (1-Tc).

Now that you know how to calculate the WACC, it’s valuable to know how to apply it and how to value what you are applying.  Because assumptions have to be made when calculating Re, the cost of equity, (assumptions either about how to calculate the beta or what the dividend growth rate will be) the number one person gets for their calculation of WACC can vary from another’s.  However, WACC still gives you a good idea of at what value cash flows should be discounted at to get their present value.  Another way to think of the WACC is the required return that a company has, as this is what they need generate in order to cover their interest on their financing activites.  The WACC is often used in Discounted Cash Flow anaylsis (DCF) to find the appropriate value to discount the cash flows at for Net Present Value (NPV).

Most people tend to think it is scary to buy a $60 stock. In reality, it is no different then buying a $2 stock. It is more of a gamble to buy a $2 stock than a $60 stock. Many big institutions that really drive the stock price up do not back $2 stocks, for the most part. They want a company they know is secure and will continue to rise in price. In a study conducted by William O’neil, the stocks that rose 200%+ in a short time all started out on average at $28.  You need to think of the stock market like eBay. If a stock is selling at $2 there is a reason it only sells for $2. This stock is not in huge dmand. The $28+ stocks as mentioned beofre are high because of demand. This means they have more of a chance to go up.  I am not saying that a $2 stock can’t go to $200 but the chances of this happening are slim to none. Make sure to buy into companies with good financials and improving earnings and revenue. These stocks are where you can make the most with the least amount of risk.

What is Growth Investing?

Growth investing is when someone invests in a company whose earnings are 20% year after year. Examples of this would be Cisco, Microsoft, and Paychex. They each had huge earning reports that beat the previous year. These stocks usually have a product that users want and has a superior profit margin.

What is a Value Investor?

A value investor is one who tries to find stocks that are priced low but have a great balance sheet and assets in their company. Basically - a company who someone thinks is undervalued. The value investor tends to like finding stocks with a  low P/E ratio or a low price to book value.

Hmm…

Now you might think that P/E ratios are everything a stock is about and that value investing is the best idea on the planet…this isn’t true.  The stocks mentioned above in growth investing had P/E ratios of over 31; that is 31 times earnings! If you were a value investor you would have not made the critical buys of the great companies, such as Microsoft in its prime years. Also, you must remember, unless you are Warren Buffet, you will not get special information on investing. Warren Buffet has teams and teams of auditors who can go through companies’ books. Just beacuase he can do it and be successful does not mean that you will be as successful. Mr. Buffet has many more tools than you will ever have, unless you plan to one day be the oracle of your town.