CAPM Fail?

I came across something funny in my stock screening this morning when I noticed something was odd with the discount rate that my (automated) valuation model was using for one particular stock, APOL. It was incredibly low, implying that APOL was a very safe investment.

APOL may very well be a good buy. I don’t currently own it, but it certainly screens well, with historically predictable yearly increases in sales, net income, and free cash flow. High ROE, current ratio, interest coverage ratio, etc. Basically it passes the test of almost everything I normally screen for.

But considering that the SEC has launched an informal inquiry into its accounting practices and that there has been the stray negative article regarding the usefullness of for-profit education in general, it seemed odd to me that APOL could be considered (by my computer) as an ultra-safe investment.

The problem, it turned out, was that during some experimentation I’d switched out my model’s standard discount rate of 14-16%, with the Capital Asset Pricing Model instead. And I’d forgotten to switch it back.

I’ve grumbled before about not liking CAPM, but there’s one thing it maybe captures well. If you’re trying to value many stocks quickly on the fly, the stocks with a history of large gaps up and down in price during quarterly earnings will naturally have a larger β, and therefore your valuation model will use a larger required rate of return (Ri) as it probably should.

Ri = Rf + β x (RM – Rf)

The problem was, my computer was basically using:

Ri= Rf

Or in other words, the future cash flows of APOL were not at all tied to what the stock market (RM) may do, but were as predictable and certain as the future cash flows of 3-month US treasury bills! (Rf)

A quick visit to Yahoo Finance’s Key Statistics Page for APOL showed why:

APOL's Beta

Which can sort of be verified by inspection:


apol_sp5

And so I’m supposed to discount APOL’s future cash flows by Rf, which is currently about 0.13%?! I don’t think so!

In the end, I decided to sort of fuse CAPM with my own usually fixed 15% discount rate (a little higher for small caps, a little lower for large caps). What I came up with was:

Ri = 14% + β

Not perfect but should keep me closer to the conservative 14-16% range for all the quick daily valuation screens. Then when I spreadsheet all the financial data for the rare stock that passes all my initial quick tests, I can tweak the model’s knobs to fine-tune the valuation.

5 thoughts on “CAPM Fail?”

  1. Hey Lumi, Congrats on all your accomplishments so far. Question: Do you have a game plan regarding how you’re going to get the 48 months full time work experience required for the charter? Or are you not going to worry about that requirement until you pass L3?

    I’m a Level 2 re-taker (failed my first attempt in ’09) also, and I don’t have any of the required work experience yet. I’ve followed your blog since I was studying for Level 1 in 2008, so I thought I’d ask. Étudiez bien.

  2. Congrats back to you Chris. No I haven’t given much thought to the work experience requirements so far. I’m still contracting part time as a financial analyst alongside my engineering work and really enjoying that. It seems like a good intermediate step for right now. Only problem is that working both jobs leaves little time for study. I might be perpetually stuck at Level 2 – but I’ll keep signing up for and showing up for the exam each year. Good luck this year – make us proud. 🙂

    -lumi

  3. Thought my Google Reader was broken since I haven’t seen a post from you in a while about the CFA Journey. 🙂

    How is the studying? I hope you are getting in 30-60 minutes a day to solve problems.

    Just finished the first CFAI sample exam and well…hmmm…umm…not sooooo good. It is very frustrating to score so low after putting in so many hours and hours solving CFAI end of chapter questions. I knew this wasn’t going to be an easy ride but man oh man, I’m starting to lose confidence in myself. Morale is near rock bottom.

    Did you have a chance to do the CFAI Sample Exams? Or the Mock Exam? Thoughts?

    Only 3 weeks left. Oh boy.

  4. Hi Yellowman – no broken reader I’m afraid – just very little time for blogging. 🙂

    I’ve been doing practice tests myself and always end up scoring lower than expected. The really frustrating thing is getting questions that you know you knew how to answer at one time, but have forgotten.

    I haven’t done the CFAI sample tests yet – just the Schweser Practice exams. I usually score between 60-70%, but it’s very inconsistent. Unlike last year though, this year after taking a practice test I study the section I performed most poorly on.

    Keep at it and remember that great phrase from that Anthony Hopkins movie (The Game?):

    “What one man can do, another can do!”

    Other people have passed, so so can we.

  5. Same here. Doing questions and getting them wrong even though I’ve done them ten times over frustrates me the most. It really seems like there is just way too much information to learn in Level 2 compared to Level 1.

    Every time I learn/refresh a topic, I seem to forget what I did yesterday.

    Plug one hole and two more holes appear.

    A quick question. Are the item sets that are provided in the CFAI Books similar to the actual exam? I am asking because after completing the CFAI Mock Exam, I found the Mock to be worded in a strange/difficult way compared to the item sets from the end-of-chapter item sets.

    Under 2 weeks to go…

Leave a Reply

Your email address will not be published.