{"id":17171,"date":"2021-07-08T09:38:11","date_gmt":"2021-07-08T09:38:11","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=17171"},"modified":"2026-06-30T19:27:34","modified_gmt":"2026-06-30T19:27:34","slug":"strengths-and-weaknesses-of-methods-for-estimating-the-required-return","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/strengths-and-weaknesses-of-methods-for-estimating-the-required-return\/","title":{"rendered":"Strengths and Weaknesses of Methods for Estimating the Required Return"},"content":{"rendered":"\r\n<script type=\"application\/ld+json\">\r\n{\r\n  \"@context\": \"https:\/\/schema.org\",\r\n  \"@type\": \"QAPage\",\r\n  \"mainEntity\": {\r\n    \"@type\": \"Question\",\r\n    \"name\": \"Which of the following estimation methods of return is most likely to incorporate only one risk premium?\",\r\n    \"answerCount\": 3,\r\n    \"acceptedAnswer\": {\r\n      \"@type\": \"Answer\",\r\n      \"text\": \"The correct answer is A. CAPM. The Capital Asset Pricing Model (CAPM) estimates the required rate of return using only one risk premium\u2014the equity market risk premium. Multifactor models incorporate additional risk premiums, such as size, value, and liquidity factors, while build-up methods estimate the required return by adding several risk premiums to the risk-free rate without using beta adjustments.\"\r\n    },\r\n    \"suggestedAnswer\": [\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"CAPM.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Multifactor models.\"\r\n      },\r\n      {\r\n        \"@type\": \"Answer\",\r\n        \"text\": \"Build-up methods.\"\r\n      }\r\n    ]\r\n  }\r\n}\r\n<\/script>\r\n<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/UnwokOxe4OM\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\r\n<h2>CAPM Strenghts and Weaknesses<\/h2>\r\n<p>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.<\/p>\r\n<p>For individual securities, unsystematic risk can overwhelm market risk and beta may therefore be a poor indicator of future average returns.<\/p>\r\n\r\n<div style=\"margin: 18px 0;\"><a style=\"display: block; text-align: center; padding: 14px 18px; border: 2px solid #2F5BFF; border-radius: 18px; color: #ffffff; font-weight: 600; font-size: 16px; text-decoration: none; background-color: #1a73e8;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\">Practice required return estimation methods with our CFA Free Trial.<\/a><\/div>\r\n\r\n<h2>Multifactor Models Strenghts and Weaknesses<\/h2>\r\n<p>Multifactor models attempt to overcome the weakness of CAPM by adding a set of risk premia because evidence suggests that multiple factors drive return.<\/p>\r\n<p>However, this adds a complexity that does not necessarily ensure greater explanatory power.<\/p>\r\n<h2>Build-up Methods Strenghts and Weaknesses<\/h2>\r\n<p>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.<\/p>\r\n<p>A downward adjustment may need to be made to the size premium estimated using public companies\u2019 data. This is because the size premium may reflect the premium of healthy small-cap companies and former large companies in financial distress.<\/p>\r\n<blockquote>\r\n<h2>Question<\/h2>\r\n<p>Which of the following estimation methods of return is <em>most likely<\/em> to incorporate only one risk premium?<\/p>\r\n<ol style=\"list-style-type: upper-alpha;\">\r\n\t<li>CAPM.<\/li>\r\n\t<li>Multifactor models.<\/li>\r\n\t<li>Build-up methods.<\/li>\r\n<\/ol>\r\n<h4>Solution<\/h4>\r\n<p><strong>The correct answer is A.<\/strong><\/p>\r\n<p>The CAPM is the required return estimation method that considers only one risk premium. i.e., the equity risk premium.<\/p>\r\n<p><strong>B is incorrect. <\/strong>Multifactor models attempt to overcome the weakness of CAPM by adding a set of other premia like size premium, value premium, and liquidity premium.<\/p>\r\n<p><strong>C is incorrect. <\/strong>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.<\/p>\r\n<\/blockquote>\r\n<p>Reading 21: Return Concepts<\/p>\r\n<p><em>LOS 21 (e) Describe strengths and weaknesses of methods used to estimate the required return on an equity investment.<\/em><\/p>\r\n\r\n<div style=\"text-align: center; margin: 30px 0;\"><a style=\"display: inline-flex; align-items: center; justify-content: center; padding: 12px 26px; border-radius: 9999px; background: #1e5bd8; color: #ffffff; font-weight: bold; text-decoration: none;\" href=\"https:\/\/analystprep.com\/free-trial\/\" target=\"_blank\" rel=\"noopener noreferrer\"> Start Free Trial \u2192 <\/a> <p style=\"margin-top: 12px; font-size: 16px; line-height: 1.5;\">Review the strengths and weaknesses of different methods for estimating the required return with CFA Level 2 study notes, practice questions, mock exams, and video lessons designed to strengthen your exam preparation.<\/p>\r\n<\/div>","protected":false},"excerpt":{"rendered":"<p>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&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,401],"tags":[216,402,424,423],"class_list":["post-17171","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-equity-valuation","tag-cfa-level-2","tag-equity-valuation","tag-methods-for-estimating-the-required-return","tag-reading-25-return-concepts","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v27.6 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Estimating Required Return Methods | CFA Level II<\/title>\n<meta name=\"description\" content=\"Learn strengths and weaknesses of methods like CAPM and APT for estimating required return, including ease of beta calculation and applicability to securities.\" \/>\n<meta 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