RELEVANCE OF CAPM FOR VALUATION ON INDIAN STOCKS

Abstract

CAPM (Capital asset pricing model) is one the widely used method for the calculation of cost of equity. CAPM model is established and researched by Sharpe (1964) and Linter (1965) and from then it has got worldwide acceptance all over the world for the calculation of cost of equity and valuation of equity shares of the company. It describes the relationship between Systematic risk and return. Investors wants to be proportionally compensated for taking the risk they were taking. The relationship between risk and return has gone long way and it has been researched by lot of researchers. CAPM is used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital. Cost of capital also use Capital assets pricing model on weighted average basis with cost of debt. CAPM is more of a subjective model which is based on the investors to calculate its determinants. CAPM Model tells us that there is positive relationship between risk and return, but over the years the companies with high market capitalization (they relatively tend to be low risky) has performed better than the low market capitalization company (they relatively are riskier). So, this shows that there are some doubts related to proportional relationship between risk and return. This problem can be arising because of its calculation risk as they take into consideration market risk only, so there are some other ways and models that we can use for the calculation of risk and return so as to make investment decision. This research will help me know the relevance of CAPM Model in India by testing its property of relationship between risk and return as this method is widely used and widely taught to college students that may leads to wrong pricing and wrong investment decision. The results show that there is negative correlation between systematic risk and return which is important property on which Capital asset pricing model work. The relevance of capital assets pricing model (CAPM) is less in Indian stocks and it can lead to wrong calculation of cost of equity and thus wrong value of assets. So, this should be used with cautious and some other methods can also be used for calculations.