Question

Explain why return on equity, calculated using the financial statements, generally differs from the return on the stock calculated using CAPM.

Answer 1

The return on equity as calculated from CAPM differs from as calculated from financial statements due to the ways in which the inputs for each of these models are derived. Let’s look at the inputs for each of these models separately-

CAPM approach

Ri= Rf + Beta * (Rm – Rf)

Factors-

Beta- beta is generally calculated based on the historical correlation between stock returns and market returns. The stock returns for the company vary each year based on the company specific (non-systemic) factors. It is possible that the beta has changed in the recent past as the behavior of the company stock has changed recently and not yet fully captured in the beta. This is especially true for fast growing tech companies.

Rm- market return is the average return of the broader market. It is the return for undertaking the systemic risk and assumes zero non-systemic risk.

Considerations-

The CAPM model assumes zero non-systemic risk. This is rarely the case when we are looking at the returns for an individual company. A single company often has non-systemic risk and the returns are often distorted by the company-specific factors.

Additionally, the returns as calculated from CAPM are expected returns based on the market factors. They do not include the idiosyncratic factors and infrequent items related to the company.

Financial statements approach-

This approach calculates the return on equity based on the actual cash flows. These cash flows capture the company-specific and are impacted by idiosyncratic factors and infrequent items. These are actual returns as opposed to expected returns as calculated from CAPM. These returns are also impacted by one-off accounting adjustments such as tax liabilities, prepaid items, salvage etc. These items are not captured in the CAPM returns.

Primarily, we need to understand that the CAPM returns ar theoretical or model returns and the returns from financial statements are actual returns. Hence, they are bound to differ. The returns calculated from the model are only as good as the reliability of the data and the realistic assumption.