The capital asset pricing model “CAPM” is a model for pricing an individual security or a portfolio. The CAPM in it’s simplistic form takes into account expected rates of return as a function of systematic, non-diversifiable risk (its beta). The CAPM provides the foundation for the very complex Modern Portfolio Theory “MPT”.
The true test of a model lies not just in the reasonableness of it’s underlying assumptions but also in the validity and usefulness of the model’s prescription. In corporate finance applications, several potential sources of error exist in the CAPM:
a) inadequate description of the behaviour of financial markets
b) betas are unstable through time, and
c) estimates of future risk free rates of return are often subjective
The deficiencies of CAPM brought forth several other pricing models such as the Arbitrage Pricing Theory (“APT”). APT arose from dissatisfaction with the CAPM’s assumptions. The APT assumes that relatively few factors generate correlation, and states the expected return on a security or an asset class ought to be a function of its exposure to those relatively few factors. But the model itself does not offer guidance as to how many factors exist or what their identities might be, and factors can change over time.
The empirical evidence to support the validity of the CAPM is poor. Accumulating research has increasingly cast doubt on its ability to explain the actual movements of asset returns. There is, however, no empirical evidence in support of any alternative pricing mode, including complex multi-factor models, as being necessarily more accurate.
In conclusion, the CAPM is useful to a limited extent and it cannot be used in isolation. The pricing of any financial asset has become a more complex task in modern financial markets. Financial managers can use the CAPM to supplement other techniques, such as APT, the DCF models etc., but inevitably in all models their own judgement is crucial.