# Capital Asset Pricing Model Discounted Cash Flow Analysis

The capital asset pricing model and the discounted cash flow analysis are both used in determining the performance of stocks. Usually, the discounted cash flow analysis discounts all probable future cash inflows of an organization, to obtain the present value of the firm. Therefore, the use of the discounted cash flow helps an investor to assess the attractiveness of an investment. When estimating the attractiveness of a broad portfolio, an investor normally uses the weighted average cost of capital. The capital asset pricing model (CAPM), establishes the minimum required return (expected return) of a stock, which is related to its systematic risk. Accordingly, the knowledge of the discounted cash flow analysis (DCF) and the capital asset pricing model (CAPM) will help in determining the suitability of the inherited portfolio.

**Discounted Cash Flow Analysis**

** **The discounted cash flow (DCF) estimates the attractiveness of an investment. Usually, the future free cash flows from an investment are discounted to predict their present value. In cases where an organization has a portfolio made of many stocks, a weighted average cost of capital is used to estimate the potential of the entire portfolio (Render et al. 71-76). The determination of whether an investment is attractive or not depends on the present value of its future cash flows as compared to the current cost of the investment. In this case, an investment is attractive if the present value of the future cash flows is more than its current value. Similarly, an investment is not attractive if its present value of future cash flows is lower than its net costs.

Discounted cash flows are calculated as follows:

PV= CF_{1}/(1+k) +CF_{2}/ (1+k)^{2} +…[TCF/(k-g)]/(1+k) ^{n-1}

Where

PV= present value

CF_{i}= Cash flow in year i

k= discount rate

TCF= Terminal year cash flow

G= growth rate assumption in perpetuity beyond terminal year

N= Number of the year in the valuation model including the terminal year (Render et al. 84).

There are usually many variations made when determining the future cash flows and discount rates in the discounted cash flow analysis. Typically, there can be the consideration of depreciation, operating profits, amortization of goodwill, capital expenditures, cash taxes, and changes in the working capital when establishing a firm’s cash flows. Overall, an analyst considers the amount of money received from a project/ stocks and discounts them to establish their present value.

**Determination of When to Buy, Sell, Hold**

** W**hen to buy, sell, or hold strictly depends on the value of the future cash flow of the investment. In this case, stocks/investments whose present value of future cash flows is greater than their net investment costs should be bought. An investor can hold those whose present value of their future cash flows are more to their current cost. Finally, an investor should sell stocks whose present value of the future cash flow is lower than their current value (Render et al. 96).

**Capital Asset Pricing Model**

Essentially, the capital asset pricing model (CAPM) measures the expected return of a stock. In a well-diversified portfolio, CAPM helps an investor to establish the possible return on his/her investment. Therefore, CAPM gives a relationship between the expected return on an investment and its systematic risk (Patrick). Accordingly, the expected risk of a stock/ investment is calculated as follow:

E(r)= R(f) + β(a)(R(m)-R(f))

Where

E(r)= Expected risk

R(f)= Risk-free rate

β(a)= Beta of asset

R(m)= Expected market return on asset (Patrick)

CAPM is founded on the assumption that investors are rational, and they weigh risks when making investments. Therefore, they should be equally compensated for risk undertaken and their time value of money. The product of the assets beta and that of the market return less the risk-free rate {β(a)(R(m)-R(f))} represents the risk premium, which shows the additional income that shareholders aim at making from their investment (Patrick). Noteworthy, any smart investor should only invest in assets that have a higher return than the risk-free rate.

**Buying, Selling, Holding Decision**

The decision of whether to buy, sell or hold a stock depends on its risk premium. Under CAPM, the expected return of a security should be more or equal to the risk premium {β(a)(R(m)-R(f))} plus the risk-free rate. Therefore, an investor should only purchase stocks whose expected return is more than the sum of the risk premium and the risk-free rate. An investor should sell stocks whose expected return are less than the sum of the risk premium and the risk-free rate (Patrick). Finally, an investor should hold his/her stocks if their sum of the risk premium and risk-free rate is greater than the expected return.

Some of the major weaknesses with CAPM are its assumption that shareholders hold well-diversified portfolios, which is always not the case. Accordingly, CAPM wrongly assumes that investors can be able to eliminate their systematic risks, which is not true since most of them do not have properly diversified portfolios. CAPM also assumes that all investors are rational and risk-averse, which is also wrong. In practice, some investors are naïve in stocks and make irrational decisions, while some make irrational and risky decisions with the hope of making more money, such as speculators (Patrick). Finally, CAPM assumes that all investors have perfect access to information, which is not always the case.

Works Cited

Patrick, Lynch. *The Risk and Return Relationship Part 2-CAPM*. 2004. Accessed 20 February 2018, http://www.accaglobal.com/pk/en/student/exam-support-resources/professional-exams-study-resources/p4/technical-articles/risk-return.html.

Render, Barry et al. *Quantitative Analysis for Management (12 ^{th} Ed.).* Pearson, 2014.