Question

Data-Set: “Car Companies –02.19.2019” –first page of which are Treasury Interest Rates Background: Musk tweeted…. Going Private… Funds Assured!!! Well, maybe not. Musk gets sued. Tesla gets sued. Stock price goes up, goes down, goes everywhere… Musk steps down as Chairman and both Musk and Tesla settle their lawsuits with the SEC. Tesla still has Musk as CEO – but now under control. Well, that was until 02.26.2019 when he tweeted again, and violated his SEC restraining order. Out of control – but a genius. Anyway, the stock of Tesla is down over 20% from its earlier high, so it now looks attractive. A friend is fascinated by the explosive growth in Tesla but and he is thinking of investing based solely upon its growth prospects and the new (governance) stability. However, they are also intrigued by how “cheap” General Motors, Honda (HMC) and Toyota appear to be… particularly since they have decent dividend yields. Wants to buy one of these 4 auto stocks, and plans hold this auto investment for five years and then sell to buy a larger house. This auto stock will be their complete exposure to large-cap “domestic” stocks held for investment. You remind your friend that Tesla is not “just” an auto company, and in fact, is partially a battery company, a software company, and an alternative energy company. Likewise, Honda makes lawnmowers, mopeds, and motorcycles, and Toyota make Hino Trucks and other heavy equipment. GM has a truck and other businesses. Tesla exports, but GM, HMC and Toyota are truly world-wide. The Data and the Question: Assume that R(m) is 9.5%. Answer the question as if it is 02.19.2019, the date I started printing out this information. You will see that the stock price moves a bit “after hours” on the 19th, and is also a bit different for those sheets printed on the 20th of February, but assume that it is the close of business on 02.19.2019 (and I circled that day’s closing stock price). There are lots of pages for each of the four auto stocks, but you really only need the 1-page Summary Sheet (there might be 1 or 2 things of interest for a more in-depth analysis on the Statistics page). You can clearly see that Tesla does not pay a dividend, but the others do. The dividend rates (and percentage yields for the dividends) are the annual numbers (so each quarter would be 1/4th of that… so use these annual rates). You can ignore whether this a forecast dividend rate or the actual trailing dividend rate over the last 12 months. You see that Yahoo measures the Beta (using whatever methodology they utilize) as 1.03, 0.05, 0.77 and 0.86 for GM, Tesla, Toyota and Honda respectively. Your friend is a statistics freak and researched that the R2 of those Beta measurements as 0.78, 0.18, 0.74, and 0.81 for GM, Tesla, Toyota and Honda respectively. Your friend can’t read a balance sheet or income statement but thinks they know the CAPM and, having listened to a radio-talk show pundit, believes it to be accurate and reliable. Any advice for your friend???

Answer 1

While CAPM is a valid model to explain the expected return on equity based on the market risk premium, beta and the risk free rate, however the SML assumes that the correlation coefficient of beta regression is 1.0 .

This is a major limitation and short run volatility due to news and events cannot be explained by CAPM. So in real world situation, the CAPM is not able to explain some of the extra returns, both positive and negative, which may be due to market imperfections.