Company valuation in thin markets, how does CAPM perform

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Professional investors routinely use a Capital Asset Pricing Model (CAPM) – based procedure for the valuation of companies in two steps: (1) first, a financial planning model will generate the expected stream of cash flows, and then (2) today´s value of this stream will be estimated through the use of a standard discounting procedure in order to specify its present value (PV). The discount rate employed is called “opportunity cost of capital”, or “cost of capital” for short. CAPM´s elegance lies in the fact that it employs a market price for risk to arrive at this number, is both easy to implement and widely accepted. From an empirical perspective, it is probably the most heavily tested proposition in all of business and economics research. The relevance of “cost of capital” in company valuation is obvious: the larger this number, the lower the value of the given company will be. It can be interpreted as a number which accounts for the investors´ appetite for return given a specific level of risk that they attribute to this type company. In this sense, cost of capital reflects investors´ preferences for risk and return simultaneously. One of the major data inputs needed to apply CAPM is historical information on the company´s share prices. While this type of information is readily available in liquid markets, this is not the case in illiquid, sometimes called “thin” markets. These markets are characterized by periods without any trading activity as well as erratic price behavior.