Running Head: Evaluating Asset Pricing Models

Evaluating Asset Pricing Models Kyle Narcisse TUI University

Evaluating Asset Pricing Models

The rate of return on investment is tantamount to an investors decision to assume risk through investment in a business organization. There are many tools in the field of finance to evaluate risks for investors. However, the main tools used are the following three models: 1) The Arbitrage Pricing Theory 2) The Dividend Discount Model 3) The Capital Assessment Pricing Model. These are the most widely used models to determine whether an investors investment through stock in an organization will ultimately pay off for that investor through dividends and equity in the organization. The final result will thus invariably heavily influence whether an investor is willing to invest in an organization. Each theory has its uses and each theory is used by investors to evaluate their risk capital. The investors of GameStop could, as a result, use each of these models to varying degrees of accuracy when evaluating risk capital. However, this evaluation of each of these models will show that for GameStop investors the Capital Assessment Pricing Model is best for evaluating investor discount rates when compared to the Dividend Discount Model and Arbitrage Pricing Theory. The Dividend Discount Model is a very useful tool for evaluating long term discount rates on dividends for investors. It should be noted that there are many forms of the Dividend Discount Model. One of the most used models is the Gordon Growth Model. The Gordon Growth Model is a good evaluator of expected dividends in the next time period, the cost of equity and the expected growth rate in dividends. It essentially accounts for the assumption that a company will grow in the future and thus with it its dividends as well. The Gordon Growth Model is best for slow growing organizations that grow at a similar rate to the economy itself or a generally steady rate

Evaluating Asset Pricing Models that are expect to grow at this rate forever. This model is very good for organizations such as utility companies that generally grow at a steady state.

The multiple stage Dividend Discount Model is used for organizations that might not grow at a steady state. This model is used to evaluate the growth of organizations that may grow at a fast rate a one finite period and grow at a steady rate after. The Dividend Discount Model is fairly easy to use in theory. The following equation shows the ease of the Gordon Growth Model: (Expected dividends in a future period / Required rate of return for investors Growth rate in dividends forever = value of stock) The Dividend Discount Model looks simple in theory; however there are some major problems when applying this method to the valuation of GameStop. For starters, the Gordon Growth Model is not excellent for non stable companies because it forces the user to forecast future growth. An evaluation of GameStop stock over the past ten years shows that the stock has increased an average of ten dollars with a huge spike in price in 2008. This is hardly a stable growth rate. For GameStop the Dividend Discount Model would produce a very accurate picture of the organizations growth and dividends because of the potential for volatile changes in GameStops stock price that may be very hard to predict for investors. The Dividend Discount Model has some major flaws. The first major flaw of this system is the fact that DDM forces the user to make some major assumptions about an organizations future dividend growth rates, interest rates, and growth patterns. The Dividend Discount Model also becomes obsolete if an organization decides not to pay dividends but rather reinvest earnings to drive stock prices higher. The Dividend Discount Models accuracy is really based on the investors ability to correctly

Evaluating Asset Pricing Models predict certain things about an organization; without correct predictions the Dividend Discount Model loses its accuracy.

The Arbitrage Pricing Theory can be a very accurate but can also be very difficult to use. The Arbitrage Pricing Theory attempts to measure the price of a security by adjusting for macro economic and company related risks. Each risk can be calculated into the Arbitrage Pricing Theory formula to get an accurate assessment of the return that a security should yield. Out of the three aforementioned methods for assessing stock risks and value, the Arbitrage Pricing Theory is probably the most difficult to use. The difficulty of using this model is assessing each factor that can influence a stocks risk and because the theory does not rely on a measurement of the stock market. This can be one factor or twenty. The theory states that any and all factors that can significantly influence the price should be added to the formula. However, the theory does not allude as to what factors should be taken into account adding to its difficulty of use. The Arbitrage Pricing Theory can be the most accurate of the three models if used properly. When the user knows what factors drive the risks of a stock they can accurately plug in these factors and determine the rate of return on their investment. In the case of GameStop, some of these factors can obviously be determined such as interest rates, consumer spending, and economic growth. However some factors can be difficult to measure such as GameStops pending actions in regards to the video game markets transformation to digital distribution of media. In the end it is the same multiple factors that adds to this models accuracy that also works against it adding to its difficulty of use. In short the Arbitrage Pricing Theory is really only as accurate as the user is intelligent.

Evaluating Asset Pricing Models The Arbitrage Pricing Theory does make some good assumptions as to user

behavior. The Arbitrage Pricing Theory correctly assumes that all investors are different and as such have different portfolios with different assumptions about risk. The Arbitrage Pricing Theory also correctly assumes that different markets can possibly have pricing variations that can value an identical stock at two different prices between markets. The Capital Asset Pricing Model is probably the most widely used asset pricing model. It has been widely used since its inception in 1952. The Capital Asset Pricing Model evaluates the risk of a stock relative to the risk of the market using the following formula: Required/Expected Return = Risk Free Rate + (Market Return Risk Free Rate) x Beta. The Capital Asset Pricing Model is relatively easy to use. Finding the risk free rate is as simple as finding the current rate for U.S. Treasury Bills. The market return rate can easily be found on the internet. The hardest part of this equation is finding the organizations beta. However, even this can generally be found on the internet currently. For smaller organizations that might not be listed on the internet the user will have to evaluate the variances between the market rate and the average rates of return for the stock being evaluated. GameStops beta information can conveniently be found online. While no pricing model is one hundred percent accurate the Capital Asset Pricing Model is so widely used that it can be considered as fairly accurate. Very large financial organizations use the Capital Asset Pricing Model to assess risks and make this information available to the public. It should be noted though that the Capital Asset pricing model is not as accurate as the Arbitrage Pricing Model when all risk factors are

Evaluating Asset Pricing Models known, but it is very difficult to accurately identify all risk factors involved with a security. The assumptions made by the Capital Asset Pricing Model are fairly reasonable however they are by no means perfect. One of the major assumptions made by the

Capital Asset Pricing Model is that all investors think similarly in their assumption of risk and returns. While this is probably largely true it is not one hundred percent true. One of the more serious flaws of the Capital Asset Pricing Model is that it does not take into account factors that may affect a stock outside of the market portfolio. Investors typically care about more factors than just the position of the market. Another incorrect assumption that is made by the Capital Asset Pricing Model is that a portfolio is made of stocks without account for equity in real estate, art, and many other forms of investment not considered a stock. Another fatal flaw that the Capital Asset Pricing Model makes is that securities will faithfully follow the Security Market Line. However anomalies that deviate from this line are not explainable under the Capital Asset Pricing Model. When all factors are taken into account the Capital Asset Pricing Model comes out on top of the other models because of its ease of use and relative accuracy. While Capital Asset Pricing Model is not perfect, none of the models are perfect. In reality using these models in conjunction with each other would yield a more accurate result, but the Capital Asset Pricing Model is best when evaluating individual models.

Evaluating Asset Pricing Models References Clark, T. (2000). Earnings Growth and Stock Returns. Retrieved from http://www.dfaus.com/library/articles/earning_growth_stock/ Del Vecchio, John. (2000, April 6). Dividend Discount Model. Retrieved from http://pages.stern.nyu.edu/~adamodar/New_Home_Page/articles/ddm.htm Dividend discount models (n.d.). Retrieved from http://pages.stern.nyu.edu/~adamodar/pdfiles/valn2ed/ch13.pdf McClure, Ben. (n.d.) Digging Into The Dividend Discount Model. Retrieved from http://www.investopedia.com/articles/fundamental/04/041404.asp Moneyterms.co.uk. (n.d.). Arbitrage Pricing Theory. Retrieved from http://moneyterms.co.uk/apt/ Moneyzine.com (n.d.) Arbitrage Pricing Theory or APT. Retrieved from

http://www.money-zine.com/Investing/Stocks/Arbitrage-Pricing-Theory-or-APT/ The Gordon Growth Model. (2008). Retrieved from http://www.investopedia.com/terms/g/gordongrowthmodel.asp