CAPM is not a Good Cost of Equity [DCF, WACC]
CAPM Assumptions are Not True
One assumption of CAPM is that there is a single holding period for everyone. WRONG. Boomers exist and I want to make enough money to put it into dividend stocks. Therefore, a good model is based on each individual and we are not at the point of churning out models based on individual preferences or generalizing what most investors follow. Let me give you a tip. Most investors, people, don’t know what the hell CAPM is. The second assumption is no taxes. This one is okay. Bad since corporate taxes do exist and are a lot, okay because registered accounts exist where investors with thousands of dollars can earn money without pay taxes on capital gains or dividends.
Inspiration for This Post
Recently, I read a Reddit post of a DCF Analysis on GOOGL where the cost of equity for Alphabet was “calculated” to be 9% using CAPM where a risk premium was 4.6% (source is one professor and this is apparently on the low end of the range 4.5 - 5.5% of all models according to Tim Koller of Wharton), and the Beta is 1.06 (source is yahoo). This seemed odd to me because GOOGL is a tech stock and one that performs well. 20% annual compound rate of return for 5 years, and 16% for 10 years. In my eyes, the expected rate of return for GOOGL is 16% annually as that is what investors have been receiving.
ke = Required Rate of Return
The entire point of discounted cash flow model valuation is to use a required rate of return for the equity investor. In the case of us, we want 10-20%. If we wanted 10%, we should just take debt and put it into the market and get a nice 5% bonus return…That’s called a risk-adjusted return. Trusting a cost of equity is like saying investors know what they are doing. No they don’t. No we don’t. So then I say, let’s just use a cost of equity for people like me who seek alpha. We want to buy relatively undervalued companies that can grow at 20%+ with high probability somewhere down the line.
And that’s why I am bullish on GOOGL. They operate Google Search Engine, the best search engine which gives websites and real live data. That is not going to be replaced by perplexity nor by openai because when I want to read stuff, not just a summary.
Higher Capital Gains Come from Value (Insight)
intelligent people make decisions based on opportunity costs
Intelligence and finance should go hand in hand but we find that it is the complete opposite when it comes to the stock market. We need to realize that an IQ of 100 is really really dumb. Why do I say that? Because I go to university and I see the kinds of people here, and I see the kinds of people in Computer Science itself. I recently passed a tutorial where the average was 50% and I got a 92% after a 5% late penalty (due to submitting incorrectly). If the average IQ is 124 in CS and the average mark for a CS test is 50%, it’s almost as if an average IQ of 124 is just the bare minimum.
So then the average IQ of an investor is also 100. Not to mention IQ has nothing to do with returns. IQ just means capability. You still need to apply IQ to gain an advantage. Research takes time and IQ reduces the time it takes to make decisions. Anyways thanks for attending my ramble of the day. Wasted hours on this, but mostly because my midterm went well.