Question

The Capital Asset Pricing Model (CAPM) is a powerful analytical tool use for calculating the price of common stock. After reflecting on theory and application of the CAPM model and reviewing the prior work on the Constant Dividend Growth Model post a response to each of the following questions.

Question 1

What are the primary advantages and disadvantages of the Capital Asset Pricing Model (CAPM) and the Constant Dividend Growth Model for use in pricing common stock?

Question 2

Can either or both of these two models be used to price the stock of Gamma Inc., a non-publicly traded company that does not pay dividends? Explain your answer.

Question 3

Why is it that the financial models for calculating the price of a stock cannot be reliably used to make day to day investment decisions in the stock market?

Answer 1

Question1:

Capital asset Pricing Model (CAPM):

Advantages:

• It is simple to use
• Used for diversified portfolio, thus eliminates unsystematic risk.
• It takes into account systematic risk, which Dividend Growth Model does not consider

Disadvantages:

• It considers a risk free rate . But this rate is not accurately defined and Government Bond yield has daily variation
• The calculation of market return and portfolio Beta are derived from historic data. These may not predict future accurately
• Cannot determine stock value not traded in market

Constant Dividend Growth Model (DDM):

Advantages:

• It is easier to understand since it just calculated discounted present value
• It can be used for shares not traded in the market

Disadvantages:

• Constant dividend growth model does not take into account variability of growth rate
• It ignores factors like market returns and market sentiments
• It cannot value stocks having good income and growth but no dividend

Question 2

CAPM model cannot be used for Gamma Inc because market data for this stock is not available

DDM model cannot be used for Gamma Inc , because the expected dividend amount, based on which all calculations are done, is not available

Question 3

All the calculations in these models, like stock Beta, market return, dividend growth etc are done by past historical data, which may not be an indicator of future.

It is like driving a car by seeing the rear mirror.

Moreover, Uncertainty can neither be measured , nor predicted.

No cause and effect relationship is used in these analysis

Hence these are only indications and cannot be reliably used to prediction of stock price accurately