Capital Asset Pricing Model versus Cash Flows Method

CAPM is one of the most reliable tools that can be used to determine the investment risks involved in a business venture by analyzing those risks against the expected returns (McClure, 2006). Every trader wants to invest in a venture where there are few risks, but then the risks are low the returns are also low hence those who want to get the best out of a market invest in markets that have many risks. But they do not go blind because they evaluate the market indicators and find out whether the market is likely to favor them.

According to Nelling (2010), investors try to limit risks by investing in different stocks so that if the market declines in one counter they can still reap from other stocks that have not been affected. In CAPM the traders consider systematic risks which are unavoidable such as civil unrest and decline in the economy. The other risks are said to be unsystematic hence they are perceived to be influenced by the trader, by ignoring certain aspects such as the market trends. Most traders are always worried about systematic risks because there is nothing they can do to avoid them.

CAPM ensures that traders have a perfect capital market because their securities worth is accurately allocated and their proceeds will be presented in the security market line. The appropriate capital market is achieved by eliminating the taxation and operational expenses and the details are accessible by multiple buyers and sellers in the market.

There are various disadvantages of CAPM. One of the disadvantages is that for CAPM to be implemented, values have to be identified for the risk-free rate but then these values are not constant because they are prone to changes as new events unfold. In addition, the values are not easy to come by. Secondly, difficulties can be experienced when applying CAPM to compute the interest rates because an organization may have balances that are yet to be traded.

On the other hand, Discounted Cash Flows (DCF) method helps traders to analyze the stocks market and identify the stocks that are undervalued by contrasting the price-earnings against the price-to-sales ratios, unlike the CAPM which concentrates on risk assessment. DCF assists traders to determine which stock counters are likely to have price increments in the future. This is where most traders fail when they don’t take their time to analyze stocks before buying them.

Nelling (2010) argues that DCF is guided by cash flows which are said to be efficient tools because they can overcome the assumptions that could be misleading to the trader. This model can account for all transactions and thus determine what proceeds are available for the trader. DCF is vital to organizations that are interested in discovering the source of their value. This model saves organizations from the hustle of having to draft a stock value cost because all they need to do is insert the organization’s present stock value cost into the DCF model and thereby get recommendations of what is to be done for the cash flows to accumulate faster towards accomplishing stock cost.

One of the disadvantages of this model is that for beginners it may not work well if the organization does not do its arithmetic well. This is because the market may go against the expectations of an individual and thus ruin the chances of getting the expected proceeds. For instance, the growth and interest rates may move in the opposite direction hence the investor will incur losses.

DCF can be misleading because there is no guarantee that the buying and selling prices will move in the same trend in the future. This is because market prices are determined by issues such as political stability hence the values of the market trend can never be permanent. Furthermore, this model is appropriate for long-term investors hence those who are in short-term benefits are not recommended to apply this model. This is because stock prices take long time frames to improve than the time taken to decline. Stock prices may take several years to record an improvement in price while it only takes a few days for the same prices to come down.

References

McClure, B. (2006). The Capital Asset Pricing Model: An Overview. Investopedia. Web.

Nelling, E. (2010). Business Valuation Demystified. New York: McGraw-Hill.