The workhorse cost of capital (CC) model for nearly half a century has been the Capital Asset Pricing Model, or CAPM. It dominates textbooks, teaching, and practice. Over 90 percent of all publicly-traded companies use it. Courts and appraisers also use it. In many contexts, it is even the only accredited model. Unfortunately, the CAPM is not just imperfect; it is so badly wrong that it is best ignored.
All models are wrong—they are only models, after all. So why be so harsh to the CAPM? Because the CAPM is worse than just a little wrong. The data proves that the CAPM is worse than useless. The primary disagreement which remains among finance professors is whether it is merely worse than useless or statistically significantly worse than useless.
Ultimately, the CAPM provides one basic prediction: high-beta stocks should outperform low-beta stocks on average, because high-beta stocks are riskier. Unfortunately, the data say the opposite. Even over long periods, average rates of return have been higher for stocks with low betas than stocks with high betas—the opposite of what the CAPM claims. The CAPM prescribes high expected returns for exactly those stocks and industries that have shown low average returns, and vice-versa.
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