The theory of Capital Asset Pricing Model (CAPM) is one of the most important in finance theory. The theory was proposed by such theorists as William Sharpe, John Lintner and Jan Mossin in the 60s of the last century based on Harry Markowitz’s theory of portfolio. Everyone involved in investing knows that risk equals reward.
Capital asset pricing model (CAPM) shows how they correlate; it is often applied by fund managers and others involved in the financial sector to assess whether an investment should be made or not. As a result, investors get the answer on their decision based on CAPM calculation. This article intends to describe how CAPM cand be applied correctly when it comes to estimate cost of equity for a single-asset junior miner.
The capital asset pricing model (CAPM) is one of the instruments which can help the investors evaluate whether the rate of return that is expected to result from the investment is worth considering in connection with its risks.
This financial technique is based on certain assumptions regarding the future returns, individual risks of the investments in question, as well as general market risks and requires knowledge of the stock markets. The businesspeople who are not involved in finance can use this formula technique to allocate their extra money, be it securities investment or some other companies’ funding. Nevertheless, since risk tolerance is a rather personal trait, CAPM must serve one of the criteria for investors.
Fundamentally, CAPM is a model that enables us to find out if an investment is balanced relative to its inherent risks. The model operates with incremental risks above some “risk-free” level (we will talk more about this later). CAPM is based on an economic principle of the cost of opportunity, where the choice of one alternative inevitably implies losing other.
As an illustration of the latter, let’s look at an owner of a firm who can keep extra cash in a safe money market and receive interest income of 1%, or invest this extra cash in some risky stock and possibly earn bigger dividend payments from the stock or even see the price appreciation.
By doing this, the owner will not have an ability to earn 1% of interest income on cash in the money market account anymore. CAPM seeks to find out if the return from the stock is proportional to its risks more than the cost of the safe alternative. If lower returns, i.e., those below some threshold calculated via CAPM, an investor only interested in maximizing his/her wealth will probably not buy the stock. Otherwise, s/he might choose otherwise.
A direct application of this conventional theory on the case of an individual asset junior mining firm poses a huge problem because of high idiosyncratic risks that arise as a result of heavy exposure to high project-related uncertainties such as failure in the process of exploration, long permitting delays, and price instability in commodities market. The issue with this type of junior mining firms is that their trading data in the past is inadequate enough to come up with a beta.
These issues can be overcome by financial specialists who will modify the CAPM to address these weaknesses. Instead of estimating a faulty or non-existent historical beta, it is customary for analysts to build a bottom-up beta by comparing equivalent companies in the mining sector. Moreover, due to the complex nature involved in extracting natural resources, it is usual for financial specialists to incorporate a risk premium above the traditional CAPM rate according to the development phase of the project.
Mathematical precision is just as crucial when calculating the above factors for the extremely volatile stocks in the mining sector. The conventional method of regression analysis through Ordinary Least Squares assumes certain prerequisites relating to the nature of data being used. Due to the occurrence of extreme values in return rates for mining junior stocks, such calculations using OLS might not be very reliable. Robust regression via optimization would be useful in addressing this issue.
In summary, although CAPM is the primary means of calculating the cost of equity, its unmitigated application to a one-asset single junior miner would generate faulty valuations. It is necessary for analysts to go beyond theoretical formulae, and instead, make use of bottom-up betas obtained from peer analysis, risk premiums tailored to each growth phase, and rigorous regressions capable of eliminating market noise. With an appropriate tweak to the formula, one can arrive at an effective cost of equity figure.
