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Victoria explains that the second part of the modified CAPM is the equity risk premium . This is the
extra return investors require above a risk-free rate to invest in risky stocks. A common benchmark for
the equity risk premium is the returns of the S&P 500 stock index. Several researchers and
commercial data providers have analyzed historical equity risk premiums. For instance, Morningstar‟s
Ibbotson Associates performs annual empirical studies of the historical equity risk premium going
back to 1926. Since investors in private firms have long investment horizons, business valuation
theory uses an equity risk premium with a long-term perspective. Based on her research, Victoria
believes a reasonable estimate of Acme‟s equity risk premium is 8.1% above the risk-free rate.
The modified CAPM uses the sensitivity of a firm‟s stock price to swings in the broader market.
Beta is a measure of the relationship between the returns on an individual stock to returns of the
overall market. A proxy for the market is often a stock index such as the S&P 500 index. Moreover,
the prices of some stocks tend to rise and fall faster than the overall market. When a stock‟s beta is
greater than 1.0, its returns tend to be more volatile than those of the market. Alternatively, a stock
with a beta below 1.0 tends to be less volatile than overall market returns. In summary, beta measures
a stock‟s volatility relative to the overall market. If a stock has a beta greater than 1.0, its returns are
more volatile and, therefore, it is riskier than the overall market. If beta is less than 1.0, its returns are
less volatile, and it is less risky than the market.
One can obtain beta measurements of public stocks from free Web sites like Yahoo! Finance or
MSN Money and from proprietary financial sources like Bloomberg. But how does one get the beta of
a private firm to apply the modified CAPM? One way is to use the average beta of public firms that
are in the same industry as a proxy.
Victoria‟s analysis finds that the average beta of public firms in Acme‟s industry is 0.99. She
believes this average is a reasonable proxy for Acme‟s beta for use in the modified CAPM.