“CAPM-Based Company (Mis)valuations“ Dessaint, Olivier, Jacques Oliver, Clemens A. Otto, and David Thesmar Flashcards
What is the main idea?
Analyses suggest that using the CAPM when valuing targets leads to valuation errors.
How does CAPM no fit the data?
Well-known that CAPM doesn’t fit the data
* Av. realized returns of low β securities > than CAPM predicts
* Av. realized returns of high β securities < than CAPM predicts
* Slope of empirical SML line is less steep than implied by CAPM
* CAPM leads to valuation errors that are 12–33% of the deal values
* Bidders overvalue low- and undervalue high-beta targets relative to the market’s assessment because they use the CAPM
What are the two views about CAPM?
o CAPM holds in the long run, but market is inefficient
Then there is temporary mispricing of the market, managers are right to use CAPM
o Market is efficient, CAPM fails to explain expected returns (even in the long run)
Then bidders and sellers make valuation mistakes, managers should not use CAPM
What are the concerns about the beta estimates?
Authors’ β estimates may be noisy proxies for the actual β estimates used by managers in practice.
Target β-s may be correlated with unobserved determinants of bitter CARs (cumulative abnormal returns)
Concerns are eliminated by estimating two-stage least squares regression
What affect does using CAPM have?
CAPM-users are willing to buy (sell) low (high) beta assets at prices that the market deems too high (low).
What is the evidence against managers using CAPM?
No return reversal in the long run –> no long-lasting wealth effects for investors (log returns both short- and long-run).
The relation between target betas and bidder CARs is weaker for bidders with stronger corporate governance and for bidders with less entrenched managers – bidders are less likely to use CAPM with good CG and less entrenched managers.
These findings suggest that managers’ reliance on the CAPM may not be in the interest of shareholders
What do the authors predict about the relation between bidder CARs and target asset betas?
Prediction: bidder CARs are positively related to target asset betas.
KEY CONDITION: Risk is priced differently by the market compared to corporate managers.
How is the bidder’s CAR related to the target’s asset beta?
When bidder announces the potential acquisition, stock market reacts. The reaction is found to be based on target’s asset beta – low beta targets cause smaller bidder’s CAR and the opposite for high beta targets.
When is the positive relation between the bidder’s CAR and target’s asset beta stronger?
The positive relation between the bidder’s CAR and target’s asset beta is stronger if:
◦ The growth rate of the target’s expected operating FCFs on a stand-alone basis is larger.
◦ The relative size of the bid vis-à-vis the bidder’s market cap is larger.
◦ The bidder relies more on the CAPM-based valuation of the target (relative to other valuation methods).
How does the empirical SML slope impact the relation between the bidder’s CAR and the target’s asset beta?
The positive relation between the bidder’s CAR and target’s asset beta is weaker if the empirical SML has a steeper slope.
What are the differences between public and private targets?
*Public targets have more options when negotiating with the bidder (accepting bids, keeping shares, selling shares at current market price – private can’t do the last)
*Bidders for public targets can use market price for evaluation, for private only comparable companies
What is the relation between the bidder’s CAR and target’s asset beta if the target is publicly listed?
The positive relation between the bidder’s CAR and target’s asset beta is weaker if the target is publicly listed, in particular, if its asset beta is high.
Why do managers use CAPM?
- CAPM is the true model of the relation between risk and expected returns in the long run, but the stock market is inefficient in the short run
- CAPM may not be the true model but that managers are not aware of this
- Managers may be aware of the divergence between CAPM-implied and realized returns, but they underestimate it or use non-accurate interest rates
Should managers use CAPM?
2 questions that should be answered:
o Is the stock market efficient and returns are compensation for risk only?
o Is CAPM the true model of the relation between risk and expected returns
* If YES, then SHOULD use CAPM
