In most industries, including corporate finance, business valuation and asset management, capital asset pricing models are used to estimate a theoretically optimal market price of an asset. This type of valuation is based on assumptions about the risk of loss, as well as the expected growth rate of that asset. In many industries, there are multiple models used to develop the correct capital pricing model for each industry. Although the models themselves may have similarities, they vary in their assumptions, as well as the range of financial data needed to create their models.
The primary goal of capital pricing models is to provide accurate and consistent estimates of values for all assets. However, because the models vary from industry to industry, their results will not always be consistent across companies, due to the varying degrees of risk that companies face.
Capital asset pricing models begin with the determination of the value of each company’s stock in the marketplace. When determining the value of a company’s shares, a multiple-period
historical or projected price is typically compared to current market prices to come up with a fair value. Multiple period price comparison results in a single value estimate, called a fair value.
This single estimate is used to evaluate the risks involved with each company, and to create a capital cost allocation model. The capital cost allocation model then determines which assets will
be sold to reduce the risk of loss, and which assets will be retained to increase the company’s cash flow.
The capital cost allocation model also determines the company’s net present value of its expected cash flows, which includes all of the benefits of the cash flows, minus all of the costs associated with those cash flows. All cash flows in the model are assumed to generate a constant return, which means that any difference between cash inflows and cash inflows is assumed to be either a temporary decrease or an increase in the future. Using this method, it is possible to calculate a company’s total value, or its “net present value.” As is the case in many other areas of finance, there are typically two types of assets that can be measured in a capital cost allocation model: those assets that can be easily liquidated and those that cannot. These two categories include tangible assets such as manufacturing equipment, buildings, fixed assets, inventory and accounts receivable. Non-liquid assets include goodwill, marketable, intangible assets and available information technology. This means that, although a company can sell some of its tangible assets to a third party, it cannot often do so immediately to reduce its cash outflow.
To be able to properly calculate a company’s cash flow, an investment banking organization must use several types of capital asset classification (or classifications) to create a reasonable approximation of the total value of the company and then determine the cash flows associated with each asset classification. This involves determining the present value (NPV) and then calculating the expected future cash flows for the category to determine a company’s net present value.
In general, investors use capital valuation as a guide to assess the investment value of a company, because it helps them decide how much to invest. However, it is important to note that capital valuation is only one part of the overall value assessment process, and is typically only used to provide an estimate of value in the short term. Other important aspects of capital valuation, such as the use of discounted cash flow, discounted price to book value, and profit margin, are equally as important in the long-term valuation of any company.