Three approaches to apply CAPM

December 2019

Quite often when estimating the cost of capital (e.g. WACC) one focuses on solely to specific components and the current level of those components, while the consistent application of selected approach gets less attention. Because of this, I focus on three approaches to apply CAPM. Each of these approaches has pros and cons, but evaluation of these approaches helps one to determine specific components and increases the consistency of cost of capital estimation.

In this blog text, I am writing about different perspectives and challenges when estimating the cost of capital using Capital Asset Pricing Model (“CAPM”). Estimating the cost of capital can be challenging, especially in emerging markets where the risk is perceived to be higher due to following reasons, among other:

illiquid capital markets
macroeconomic uncertainty
high political risks
constraints in capital flows.

Although there are various methods to estimate the costs of capital, there is no singular approach that should be universally applied to all situations. There are specific aspects to consider, which include

the investor
the target company and availability of information, and
the markets in which they operate.

In this blog, the attention is primarily on the cost of equity and its application. When estimating the cost of equity, focus is on the extent of systematic risk an investor is exposed to in a particular investment.

CAPM is widely used when estimating the cost of capital. Depending on the perspective, one can consider three approaches to CAPM, which are prescribed by the “Real Cost of Capital”, to estimate the cost of equity in international markets:

“Foreign” CAPM approach

Firstly, let’s consider the so called “foreign CAPM” approach, which is based on target country’s (foreign variables) and it assumes that equity markets are segmented. This approach is dependent on the country where an investment is located and used when the target company is domiciled in a foreign market and cash flows are denominated in foreign currency of target. As yields of foreign government bonds include a premium for country risk, the foreign CAPM automatically includes a country risk adjustment (country risk should not be double counted).

For example, for a bond issued by a country (eg. Vietnam Bond), interest rate on this bond already incorporates the default spread (measure of country risk). Hence, the risk premium should not be adjusted upwards to reflect country risk of the foreign target. As default spreads measure risk associated with bonds issued in countries, rather than equity risk in these countries, some argue that the default spreads understate equity risk premium.

In summary, the foreign CAPM approach is based on (1) foreign risk-free rate, (2) foreign EMRP and (3) foreign Beta

Risk free rate of target company’s country (Rf_foreign)
Country risk premium (CRP_target): not applicable (already factored in foreign Rf)
Beta (β_foreign): Regress returns of peer companies in target’s country against target country index
Equity market risk premium (EMRP): Equity risk premium of target investment (should not factor in additional premium for country risk of target, if already implied in Rf_foreign

source: The Real Cost of Capital

“Global” CAPM approach

Secondly, let’s consider the “Global CAPM” approach, which is based on global variables and assumes global supply and demand for capital. In this approach, one considers the perspective of a global investor eg. (1) large institutional investors drawing capital from and investing globally or (2) investors with large, well-diversified corporations (eg. global consumer goods). This approach could also be considered if there is a target company with global exposure (eg. oil & gas, mining) which primarily export to global markets.

When considering the risk-free rate in this approach, one should ensure that the currency of cash flows match currency of discount rate (adjust with Fisher equation if necessary) and that the risk free rate should be denominated in nominal terms when cash flows are in nominal terms.

One of the challenges in this approach is the estimation of EMRP from a global perspective. Damodaran’s suggestion is to first estimate an EMRP of a “mature” market (eg. US) and then adding a country risk premium to cost of equity, which assumes all companies are exposed to country risk (equally).

In summary, the global CAPM approach is based (1) global risk free rate (2) single global EMRP (3) global beta

Risk-free rate: Return on eg. US government bond (Rf_global)
Country risk premium (CRP_target): additional risk of investing in target country
Beta (β_global): Measured against global market portfolio, eg. Morgan Stanley World Capital Index (MSWCI)
Equity market risk premium (EMRP): Global EMRP = US EMRP/correlation of US Market with MSWCI

source: The Real Cost of Capital

“Home” CAPM approach

Thirdly, let’s consider the so called “Home CAPM approach”, which is based on investor’s home variables. In this approach, one considers the perspective of a home investor, with partially diversified portfolio globally, and investments concentrated in home market. Like foreign CAPM approach, this approach assumes that equity markets are segmented.

In summary, the home CAPM approach is based on (1) home risk-free rate, (2) home EMRP and (3) home Beta

Risk free rate (Rf_home) of investor’s home
Country risk premium (CRP_target): additional risk of investing in target country
Beta (β_home): Regress returns of peer companies in target’s country against home index
Equity market risk premium (EMRP_home): Equity risk premium of investor’s home country (should not double count same country risk embedded in Rf_home)

source: The Real Cost of Capital

Challenges

There are some practical issues on each approach. In foreign CAPM approach, there can be potential over-estimation of CRP as country risk is incorporated in both Rf and EMRP. However, if the CRP element is removed from the Rf, the foreign country’s Rf could potentially be lower than a developed country’s Rf.

In global CAPM approach, a global EMRP is a theoretical concept and is rarely used in practice. In this approach, one may need to use Fisher equation to adjust the real rate of return to the currency-specific nominal rate.

In the home CAPM approach, there can be potential over estimation of CRP if Home CAPM is used by investor from an emerging market. In such case, CRP may need to be the difference between the two countries.