In an effort to maximize returns on investments, investors encounter diverse asset valuation models from whose results they base their investment decision. Such asset pricing models include capital asset pricing model (CAPM), dividend growth models and arbitrage pricing theory (APT). Under the dividend growth model, the intrinsic value of a stock is based on the present value of the infinite future dividends that the stock generates at a constant growth rate. If the discounting rate falls below the figure quoted by an investor, then the model suggests dropping of such an investment. On the other hand, capital asset pricing model (CAPM) is an asset pricing model that was developed by Harry Markowitz in 1952. It presents the relationship that exists between risk and return, thus forming basis for pricing risky securities. Security's or portfolio's expected rate of return is a sum of the prevailing rate of risk free securities in the market and a risk premium. If this rate is below investor's quotation, then the investor is advised not to invest but when it is equal to or above the investors expected rate of return, the investor is advised to invest. Arbitrage pricing theory on the other hand is a more complicated model that puts forward the assertion that the security price is determined by macro factors and other company specific factors. This leads to inclusion of more variables in the CAPM model to come up with arbitrage pricing approach. Capital asset pricing model relies on current market returns that are easy to calculate with a high level of accuracy, making it a more superior model that the board of directors and investors should adopt in asset pricing (Damodaran, 2005).
Ease of use of these three models
Capital asset pricing model is an easy to apply model in asset pricing. Most of the information necessary to generate asset prices is usually easily accessible from the stock markets. Risk free rate can be accessed from the information on government securities while organization returns can be easily accessed from the specific organization or the various forms of media inclined to financial reporting. The model is greatly used in investment analysis (Value based management net, capital asset pricing model, 2010).
Application of dividend growth model is not easy as the process involves use of a lot of data. Necessary data can easily be found from organizations financial reports. Due to its technical nature, it requires the user to be well versed in financial mathematics. The assumption that growth is constant while pricing assets using this model makes it easier otherwise in instances where we have irregular growth, application of the model becomes quite cumbersome. The model is limited to firms that issue constant dividends. Organizations whose financing strategy is to draw back profits while rewarding shareholders through capital gains, application of dividend growth model is impossible, limiting application of the model in many organizations (Dividend discount models, 2010).
Arbitrage pricing employs use of case specific variables in pricing of assets. This makes pricing of assets using this model complicated. Determining sensitivity of a specific stock to numerous macro and micro economic variables is also time consuming. Though this method could generate the most accurate results in a perfect world due to inclusion of many variables that affect asset pricing during analysis, in the real world full of imperfections, its application is limited( Ingram, & Albright, 2006).
2. Accuracy of each of these three models
The three models for pricing assets are applied at varying accuracy levels. This emanates from the varying fundamental assumptions upon which the models are based. In spite of these variations capital asset pricing model stands out as the superior model in terms of accuracy as it is based on current market elements such as the real risk free rate and market return whose information is easily accessible in the market. It puts into consideration the diversity in sensitivity of assets to the market, thus applying organization specific beta, which are statistically generated on existing information. On the other hand, dividend growth model computation is easy but based on vague premise. The assumption that an organization can have perpetual growth is unrealistic. Assumption of constant growth makes the outcome quite inaccurate in that, rarely do we have organizations that record constant growth perpetually due to change in their external as well as internal environment. Use of dividends in projecting price is conceptually isolated in that not all organizations have a constant dividend issuing policies. This model leads to under or overpricing of assets depending on the dividend policy that an organization employs in its financing decisions.
Arbitrage pricing theory as a method of pricing assets is theoretically more superior to the other models in that, it puts into consideration more variables that affect asset pricing. This strength is lost in application in that, the model does not specify the optimal number of variables to employ (Ross, Westerfield, & Jaffe, 2005). This makes results generated through this model to be quite subjective. Such outcomes tend to differ even when computed on the same firm by different professionals, thus lacking comparability to other assets.
3. How realistic the assumptions of each model are
Capital asset pricing model is based on a number of fundamental assumptions. The assumption that investors have homogenous beliefs about returns is quite true among the majority of investors as they are all interested in maximizing returns from their investments, assuming they are rational investors. The assumption that people access information on investment opportunities equally is practical in a perfect market but unfortunately perfect markets rarely exist and access to information may not always be uniform among the various investors. The assumption that there are no market imperfections such as taxes, regulations or short selling restrictions. The assumption that borrowing and lending at the risk free rate is possible for all market participants is not true in many markets, as they are imperfect. Depending on the specific characteristics of individual organizations, some may be able to borrow at risk free rate while others may not. For instance, for organizations that are financially strong and whose shares have high return on investment, such organization can access finances faster from the market than organizations that are weak financially and whose securities are offering low, zero or negative returns to the investor (Clark, 2000).
Under the asset pricing model, the assumption that there exist systematic risks that drive returns linearly is quite true in that, the organizations operate in an environment where they face and take various risks both from internal sources as well as external sources. Such risks do influence the rate of return of their investments and share values. It is also quite true that investors can estimate security's sensitivity to these risks although this can be achieved at very inefficient and cumbersome levels. It is also true that in the market, investors who are risk takers do exist. Risk takers are known in taking risky opportunities that has high chances of generating high returns as long a the prevailing risks are well compensated for by the expected return. This makes the last assumption true that such investors do take advantage of chances that exist for high returns through risk arbitrage (Ross, Westerfield, & Jaffe, 2005).
The dividend growth model does also employ fundamental assumptions in generation of the rate of return on equity investment. Gordon growth model is a powerful and simple tool of valuing equity. Despite its attractiveness, its application is limited to organizations that are growing at a stable rate. The assumption that growth in dividends will be maintained forever also implies that returns of the organization in terms of profits will grow constantly forever otherwise; dividends would grow to higher levels than profit. This is impossible in practice thus leading to the questioning of the models practicality in the long run. It also ignores business cycles where organizations start from infant, growth, maturity and eventually decline. The next issue is on assigning of a specific growth rate to an organization. This implies that various people may use differing growth rate projections for the same organization leading to variation in security value. The assumption that dividends will grow at constant rate is also something that is hard to achieve in the real dynamic business environment.
4. Conclusion:
In conclusion it is clear that Gordon Growth Model is applicable in organizations that are issuing and also intending to issue constant dividends in the future (Value based management net, capital asset pricing model, 2010). It is also worth noting that this model leads to undervaluing of stocks in organizations that pay out less dividends than what they can afford. On the other hand, capital asset pricing models and dividend growth models are easier to apply than the arbitrage pricing theory. Finally, it is worth noting that the accuracy of the models differs from case to case. For instance, dividend growth model can generate the most reliable results when computing security price of an organization that has constant dividend as their dividend policy. On the other hand, arbitrage pricing can generate reliable results in situations where its easy to identify variables that a security's return is sensitive to (Ross, Westerfield, & Jaffe, 2005).
The capital asset pricing model offers expected security return = Riskless return + Beta*(expected market premium on risk). That is: r = RF + Beta x (RM-RF), Where RF is the risk free rate, RM is the return of that particular asset class while r is the expected rate of return of the asset. The yield to maturity of a US Government one year bond is approximately 3%. Taking Apple Inc. as Our case organization, we can get the shareholders expected rate of return through application of the capital pricing model. Therefore, r = RF + Beta x (RM-RF) implying that r = 3+1.24(10-3) = 11.68, which is the rate of return that shareholders expect on their investments in Apple Inc. It can also be termed as the cost of equity. (Stock beta estimates as of 09/17/2010, 2010
The above rate of return for apple is above my expectation. On average, I expected the return to be approximately equal to the overall market return of 10 to 10.2%. Nevertheless, with the continuous innovations that the organization engages itself in, its rate of return has equally been shifting upwards. The organization has also expanded market for its products globally, something that has led to boosting of its sales. The organization performance moves in line with the market trends as indicated by its strong market Beta, something that leads to such an organization having a rate of return that is approximately equal to the market return or above.
Google, Amazon and Wal-Mart: Expected rate or return for share holders investing in apple Inc. can be compared with cost of equity of other firms both in related and unrelated industries. Such related companies are Dell, Google and Amazon.com. Unrelated company is Wal-Mart, which has a very low market Beta as indicated below in computation of the expected rate of returns for these companies.
Having recorded an expected rate of return of 11.68, Apple takes the lead position as compared to the other four companies. While its rate of return is close to that of a related company (Amazon.com Inc.) which is also engaged in technology driven business, other related organizations record lower expected rates of return i.e. Google and Dell. Nevertheless, the variation in expected returns for the three companies is minimal. Wal-mart, an unrelated company records the lowest expected rate of return among the four organizations, indicting its weak correlation to market trends as compared to the other technology driven companies which has to remain in tandem with the most recent market trends in technology for the to survive the current high level of competition in the industry that they operate in.
Expected rate of return differ from organization to organization, depending on its risk return components. The higher the risk those investors undertake while investing in an organization, the higher the return that they expect from such an investment (Franklin, & Keith, 2006). This confirms the reason as to why the variation in returns in the above four organizations is expected.
Dividend growth model and arbitrage pricing approach: Dividend growth model employs the use of dividends in projecting the cost of equity and price of stock. Consequently, additional information on dividend issued on common stock in Apple Inc. last year is required, average prices of its stock in the market and its rate of growth is required. With this information, it will be able to get the cost of equity, which will act as the discounting rate. This is simplified in the equation po=d1/ks where no growth exists and po=d1/ (ks-g), under constant growth, po is the price of the share, d1 is the dividend to be issued by the close of this year, ks is the cost of equity while g represents growth (The Gordon Growth Model, 2008).
Arbitrage pricing theory calls for inclusion of all elements that a security is to as long as it's possible to approximate them. This leads to inclusion of more variables in the capital asset pricing model, but unfortunately the model is not specific on the variables to be included or their exact number. Under this model, expected return is reached as per the equation: r = RF + βj1 λ1 + βj2 λ2 +...+ βjn λn, where r is the rate of return and βjn λn indicate the variables that apple stock is sensitive to.
