Capital Asset Pricing and Discounted Price Flow Models
Knowing the risk of an investment and understanding how that risk will affect any
future returns are crucial aspects in deciding if the expected return is worth the risk. The Capital Asset Pricing Model (CAPM) provides a base from which both the risk and the affects of the risk are determined by the investor while the Discounted Price Flow Model (DPCM) can help the investor decide what amount they are willing to invest in a company in anticipation of projected future cash flows.
As indicated in the previous paragraph, the Capital Asset Pricing Model is a tool used in determining the risk of an investment and in turn, deciding if the risk is worth the investment. The CAPM generally fosters the idea that not every risk is considered in determining the value of an asset; in fact, by diversification, some of the risk can be eliminated. The CAPM starts with the idea there are two primary risks involved in investments: Systematic and unsystematic.
Systematic risks are those risks, such as interest rates, that cannot be eliminated through diversification. Unsystematic risks are those risks that are inherent to specific types of stocks. As the individual investor builds his portfolio, the risks decrease. Because systemic risks are the risks that cause the most anxiety for investors and as a way to calculate those systemic risks, William Sharpe created CAPM.
With the recent spate of financial scandals, the Discounted Price Flow Model has taken on a new importance. The DPFM is used to determine a company's value based on its projected future cash flows. Forecasted free cash flows are discounted to a present value using the company's weighted average costs of capital. (Investopedia) By deve ...