Strengths and Weaknesses of Methods for Estimating the Required Return

CAPM Strenghts and Weaknesses

The CAPM is a simple and widely accepted method of estimating the cost of equity. Beta is readily obtainable for a wide range of securities and it can be estimated easily when not available.

For individual securities, unsystematic risk can overwhelm market risk and beta may therefore be a poor indicator of future average returns.

Multifactor Models Strenghts and Weaknesses

Multifactor models attempt to overcome the weakness of CAPM by adding a set of risk premia because evidence suggests that multiple factors drive return.

However, this adds a complexity that does not necessarily ensure greater explanatory power.

Build-up Methods Strenghts and Weaknesses

Build-up methods are widely and can be easily applied to closely held businesses. The estimates arrived at using this method can be used as a check for more complex models with low explanatory power.

A downward adjustment may need to be made to the size premium estimated using public companies’ data. This is because the size premium may reflect the premium of healthy small-cap companies and former large companies in financial distress.

Question

Which of the following estimation methods of return is most likely to incorporate only one risk premium?

1. CAPM.
2. Multifactor models.
3. Build-up methods.

Solution

The correct answer is A.

The CAPM is the required return estimation method that considers only one risk premium. i.e., the equity risk premium.

B is incorrect. Multifactor models attempt to overcome the weakness of CAPM by adding a set of other premia like size premium, value premium, and liquidity premium.

C is incorrect. The build-up method estimates the required return on an equity investment as the sum of the risk-free rate and a set of risk premia. The main difference with multifactor models is that in the build-up method beta adjustments are not applied to the factor risk premiums.

Reading 21: Return Concepts

LOS 21 (e) Describe strengths and weaknesses of methods used to estimate the required return on an equity investment.