PRICING MODELS

Pricing Models

Pricing Models

Ease of Use of Models

Capital Asset Pricing Model

A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.

The general idea behind CAPM is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk (Goetzmann, 1996). This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Dividend Growth Model

The official description of the Dividend Growth Model is; 'A stock valuation model that deals with dividends and their growth, discounted to today'.

This model assumes that the basis of the valuation of stock is:

The Current Dividend

Growth of the Dividend

Required Rate of Return

It is best to describe this model by using an example. Assume that a stock is paying $2.00 per year in dividends, growing at 3.5% per year (The Gordon Growth Model, 2008). The so-called variable item in this example is the investors required rate of return, which we will assume is 12.4%.

The formula for the Dividend Growth Model is:

Value = (Current Dividend * (1 + Dividend Growth)) / (Required Return - Dividend Growth)

Now, let's insert the assumptions for the example into this formula:

Value = ($2 * (1 + .035)) / (.124 - .035)

Value = $23.26

Arbitrage pricing theory

An asset pricing model based on the idea that an asset's returns can be predicted using the relationship between that same asset and many common risk factors. Created in 1976 by Stephen Ross, this theory predicts a relationship between the returns of a portfolio and the returns of a single asset through a linear combination of many independent macro-economic variables (Money Terms, 2007).

Accuracy of the Models

Capital Assets Pricing Models

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas) (Clark, 2000).

Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).

Dividend Growth Model

To calculate the value of a stock based on the dividend using the dividend growth model, you'll need three pieces of information:

1. The current dividend payout

2. The growth rate of the dividend

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