Financial_Analysis_Tools

| Financial Analysis Tools | A Managers Tool | | Brian C. ArchuletaBUSN602American Military UniversityProfessor Theodore | 25 November 2010 | | Abstract The goal of this assignment is to contrast the Capital Asset Pricing Model (CAPM) with the Discounted Cash Flows Method. Keywords: CAPM, DCF, analysis, risk, investors, return In order to contrast the Capital Asset Pricing Model (CAPM) and the Discount Cash Flow Model, we first need to understand what they are. Then, we will go into some advantages and disadvantages of both models. Finally, we will be able to contrast the two models and see which one might work best. Teachmefinance.com says that Capital Asset Pricing Model (CAPM) looks at risk and rates of return and compares them to the overall stock market (McCraken, n.d.). Businessdictionary.com defines the Discount Cash Flow (DCF) as the value of the anticipated revenue stream from an investment as of today or any given date (BusinessDictionary.com, n.d.). There are a few assumptions with CAPM: most investors want to avoid risk, and those that take risks want to be rewarded; investors are “price takers” who can’t influence the price of assets or markets; investors are not limited in their borrowing (McCraken, n.d.). There is a formula for the CAPM: Ks= Krf + B (Km-Krf) Ks= rate of return Krf= the risk free rate B= the beta Km= the expected rate of return on investment As an example: Company A has a beta of 2, and an expected rate of return of 14% (you have to guess this number based on past performance and current conditions). Assuming a risk free rate is 5%, the result would be: Ks= 5% + 2 (14% - 5%) Ks= 5% + 2 (9%) Ks= 5% + 18% Ks= 23% So, if you don’t think that Company A can produce 23% for a rate of return, the person might not want to invest in that company based on the beta. The Discounted Cash Flow (DCF) method takes into account the present value of the dollar invested. It “discounts” the anticipated returns so the investor can get an idea what the return would look like in present dollar terms. As an example, $100 dollars today would be worth $115 dollars (hypothetically) in two years, so if your calculation on $100 dollars today showing that the investment would return $115 dollars two years from now, you might think that you made money where in essence, you didn’t. It uses two methods: net present value and the internal rate of return. Both take into account the time-value of money and are similar to computing interest-income on bank deposits (BusinessDictionary.com, n.d.) In contrasting the two, the CAPM has some advantages over other methods and has been popular for more than 40 years. It only considers a systematic risk so investors can diversify their portfolios. It establishes an easy to see relationship between the required return and the systematic risk of investing. Some of the disadvantages of using CAPM are that the investor needs to assign values to variables, like the risk free rate of return which uses return on government debt. That changes daily, so the formula would have to be updated daily or by taking an average and hoping that it stays close or at least better than what you anticipated. The beta value also changes daily. The expected rate of return is more difficult in the short term because if stock prices fall below the dividend rate, it will produce a negative value. That is why using CAPM is better when used as a long term tool (Head, n.d.). The best reason to use the Discounted Cash Flow (DCF) is that it produces the closest thing to an intrinsic stock value. One of the problems with using the DCF model is if the market is undervalued or overvalued. But, investors can manage this problem by staying away from companies that look inexpensive as compared to other peers in the market. DCF’s rely on free cash flows, which produce a more reliable measurement and takes out the guesswork. Finally you can put the current stock price into the DCF model and quickly figure out how quickly the company would have to grow its cash flows to achieve its stock price (McClure, n.d.). Variables are a flaw with this method just like the CAPM. The “garbage in, garbage out” theory holds true with the DCF as well. McClure (n.d.) says that “free cash flow forecasts, discount rates and perpetuity growth rates - are wide of the mark, the fair value generated for the company won't be accurate” (para 4). This is especially true with cash flows, and anticipating what earnings will be like into eternity. A company like FedEx who have been in business for many years with solid financial recordkeeping would make using the DCF model easy. McClure uses a solid example that describes it perfectly when talking about staying vigilant with the method. Valuations are particularly sensitive to assumptions about the perpetuity growth rates and discount rates. Our Widget Company model assumed a cash flow perpetuity growth rate of 4%. Cut that growth to 3%, and the Widget Company's fair value falls from $215.3 million to $190.2 million; lift the growth to 5% and the value climbs to $248.7 million. Likewise, raising the 11% discount rate by 1% pushes the valuation down to $182.7 million, while a 1% drop boosts the Widget Company's value to $258.9 million. DCF is also better suited for long term investing than short term investing. For the investor, they need to be conservative in their inputs and not be afraid to continuously update the information (McClure, n.d.). Being a novice investor it would appear that the CAPM model would work best for me. CAPM helps to identify the risk associated with the return, whereas the DCF model values the investment with current dollar prices to make a good decision. I would make that present value based off of the risk free rate in the CAPM model and do what the model does and discount it in the formula. Staying current with the companies financials appears to be the key to continued decision making. References BusinessDictionary.com. (n.d.). Discount Cash Flow. Retrieved July 12, 2010, from BusinessDictionary.com: http://www.businessdictionary.com/definition/discounted-cash-flow-DCF.html Head, T. (n.d.). CAPM - Theory, Advantages, and Disadvantages. Retrieved July 14, 2010, from ACCA - the global body for professional accountants: http://www.accaglobal.com/pubs/students/publications/student_accountant/archive/sa_jj08_head.pdf McClure, B. (n.d.). DCF Analysis: Pros and Cons of DCF. Retrieved July 14, 2010, from Investopedia: http://www.investopedia.com/university/dcf/dcf5.asp McCraken, M. (n.d.). CAPM - The Capital Asset Pricing Model. Retrieved July 13, 2010, from Teachmefinance.com: http://www.teachmefinance.com/capm.html