There are several financial tools and methods a financial analyst can use to help them make investment decisions and help them determine the most attractive investments for a firm. When analyzing the cost of equity and the value of companies, managers can use and compare the Capital Asset Pricing Model (CAPM) and the Discount Cash Flow (DCF) method.

CAPM is a model that describes the relationship between risk and the expected return and is used when pricing risky securities. With CAPM, investors are looking to be compensated in two ways: time value of money and risk. The time value of money is represented by a risk-free rate that compensates the investor for placing money in any investment over a period of time. Risk is also calculated as the amount of compensation the investor needs for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium.

ra=rf + βα(rm-rf) where (rf =Risk Free Rate, βα=Beta of the security, and

rm=Expected Market Return).

The CAPM says that the expected return of a security or a portfolio equals the rate on a risk free security plus a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken (Investopedia). An example would be if you had a stock with a risk-free rate of 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, then the stock is expected to return 17%.

(3%+2(10%-3%)) =17%.

Capital Asset Pricing Model vs. Discounted Cash Flows Method 3

Discounted Cash Flow (DCF) method is an approach to valuation, whereby projected future cash flows (cash left over for stockholders), are “discounted” at an interest rate (also...