Capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) is a model that describes the relationship
between systematic risk and expected return for assets, particularly stocks. CAPM is
widely used throughout finance for the pricing of risky securities, generating expected
returns for assets given the risk of those assets and calculating costs of capital.
'Capital Asset Pricing Model - CAPM'
The formula for calculating the expected return of an asset given its risk is as follows:

The general idea behind CAPM is that investors need to be compensated in two
ways: time value of money and risk. The time value of money is represented by the risk-
free (RF) rate in the formula and compensates the investors for placing money in any
investment over a period of time. The risk-free rate is customarily the yield on
government bonds like U.S. Treasuries.

The other half of the CAPM formula represents risk and calculates the amount of
compensation the investor needs for taking on additional risk. This is calculated by
taking a risk measure (beta) that compares the returns of the asset to the market over a
period of time and to the market premium (Rm-Rf): the return of the market in excess of
the risk-free rate. Beta reflects how risky an asset is compared to overall market risk
and is a function of the volatility of the asset and the market as well as the correlation
between the two. For stocks, the market is usually represented as the S&P 500 but can
be represented by more robust indexes as well.
RISK AND RETURN RELATIONSHIP OF
GlaxoSmithKline: The British Multinational
Pharmaceutical Company
Company overview
GlaxoSmithKline (GSK) is a British multinational pharmaceutical company with
headquarters in Brentford, Middlesex, United Kingdom. The company also has a
significant presence in the US, with offices in Philadelphia, Pennsylvania, and Durham,
North Carolina.
GlaxoSmithKline is a global company with commercial operations in more than 150
countries. It has a wide network of 84 manufacturing sites in 36 countries, and large
research and development centers in the United Kingdom, the United States, Spain,
Belgium, and China. Because GSK is headquartered in the United Kingdom, the
company reports its financial results in British pounds.

Mission
Our mission is to help people do more, feel better, live longer.

The business is focused around the delivery of three strategic priorities which aim to
increase growth, reduce risk and improve our long-term financial performance. These
priorities are: grow a balanced global business, deliver more products of value, and
simplify the operating model.Operating responsibly and ensuring our values are
embedded in our culture and decision-making helps us better meet the expectations of
society.

Aim
We have been creating a more balanced business and product portfolio, capable of
delivering sustainable sales and earnings growth and improved returns to shareholders.

This is centered on our three business areas of Pharmaceuticals, Vaccines and

Consumer Healthcare.

Highlights
 £23.9bn Group turnover
 39% Group turnover outside USA and Europe
Share price performance
The above graph shows the share price performance of GlaxoSmithKline against its
peers. On an annualized basis, the company delivered returns of 3.5% from June 2010
to June 2015. In the same timeframe, peers like Merck (MRK), Novartis (NVS), Pfizer
(PFE), and Johnson & Johnson (JNJ) each delivered an annual return of 10%, 15.8%,
17.2%, and 10.7%, respectively. During the same period, the annualized return for the
SPDR Health Care Select Sector ETF (XLV) was 20.1%.
Investors interested in GlaxoSmithKline should keep in mind the currency fluctuations
between the US dollar and the pound. An appreciating US dollar against the pound
could have a negative impact on GSK’s US listed stock price, while a depreciating US
dollar may benefit the company’s stock price. There is a natural hedge for GSK’s
revenues from the US.

The average rate of the US dollar per pound was $1.59 in 2012, $1.56 in 2013, and
$1.65 in 2014. The average rate for the year is calculated as the average of the 4 p.m.
buying rates for each day of the year. These conversion rates have been used
throughout this entire series on GSK.

GlaxoSmithKline’s Associated Business Segments

GlaxoSmithKline (GSK), the British pharmaceutical company with a significant
worldwide presence, deals in the following business segments:

 Pharmaceuticals

 Vaccines

 Consumer Healthcare
GlaxoSmithKline’s Financial Performance
GlaxoSmithKline (GSK), the world’s sixth largest pharmaceutical company in 2014,
deals in pharmaceuticals, vaccines, and consumer healthcare. The company’s
Pharmaceuticals segment contributed over 67% to its total revenues for 2014.

Revenues
GlaxoSmithKline’s net revenues decreased by over 13% to 23.0 billion pounds (or $38.0
billion) in 2014, compared with 26.5 billion pounds (or $41.3 billion) in 2013. The
revenues for the Pharmaceuticals and Vaccines segment declined by about 4% at a
constant exchange rate (or CER) in 2014, compared with 2013 figures. This was due to
lower Pharmaceuticals and Established Products sales in the US markets, partly offset
by increased sales in emerging markets and ViiV healthcare.
Also, the global vaccines sales declined in 2014 due to lower sales in Europe and
Japan. The Consumer Healthcare segment’s revenues declined nearly 1% at a constant
CER in 2014, compared with 2013 figures, as a result of supply disruptions.

Costs
The costs for GlaxoSmithKline are compared in the chart above. Overall, the gross
profit margin has been approximately 68.2% for 2014, an increase of ~0.5%, compared
with 2013. The operating profit margin was 28.7% in 2014, which is 1.4% lower than in
2013.

The cost of sales includes the materials and production costs. These were 7.3 billion
pounds (or $12.0 billion) in 2014 and 8.6 billion pounds (or $13.4 billion) in 2013. The
cost of sales increased as a percentage of turnover by nearly 0.8%. This was due to
declining pharmaceutical sales and continuing investments in new launch capacity and
future manufacturing technology. This decline was partly offset by the benefits of cost
reduction programs.

The selling, general, and administration (or SG&A) costs were 7.1 billion pounds (or
$11.7 billion) in 2014 and 7.7 billion pounds (or $12.0 billion) in 2013. An increase of
0.4% in SG&A costs as a percentage of sales in 2014 was driven by continued
investment in multiple new product launches, partly offset by the benefits of its
restructuring programs.

The R&D expenses were 3.4 billion pounds (or $5.6 billion) in 2014 and 3.9 billion
pounds (or $6.1 billion) in 2013, reflecting the phasing of ongoing project spending, the
completion of several programs, and cost management efforts.

Royalty income was 310 million pounds (or $511.5 million) in 2014 and 387 million
pounds (or $603.7 million) in 2013.
Risks for GlaxoSmithKline
GlaxoSmithKline (GSK) faces the following risks in addition to specific risks of the
pharmaceutical industry.

1. Patient safety
In its 2015 20-F filing with the SEC, GlaxoSmithKline notes, “Pre-clinical and clinical
trials are conducted during the development of investigational Pharmaceutical, Vaccine,
and Consumer Healthcare Products to determine the safety and efficacy of the products
for use by humans.”

However, at times, some unanticipated side effects become evident only once these
products are widely introduced in the marketplace. The company is currently a
defendant in a variety of product liability lawsuits, including class actions that involve
significant claims for damages related to its products.

1. Intellectual property
GlaxoSmithKline deals with innovative products in all segments, and any failure in
securing and protecting its intellectual property rights may lead to huge losses.
Obtaining the necessary patents and proprietary rights with respect to its products is
critical for the company’s business strategy and profitability, as well as to the
potential success of a product.

2. Supply chain and quality

The failure to comply with current Good Manufacturing Practice (or cGMP) for any of the
following factors may have major implications on patient and consumer safety:

 In-house manufacturing processes

 Distribution channels

 Contract manufacturing

 Suppliers of raw materials

 Inadequate quality checks

These factors may also affect the launch of new products, a shortage in supply of
current products, and product recalls due to quality issues. All these issues attract
regulatory, legal, and financial consequences that could materially and adversely affect
the reputation and financial performance of the company.

3. Legal, regulatory, and compliance

GlaxoSmithKline works to comply with all applicable laws, rules, and regulations, as any
failure to comply may result in civil or criminal legal proceedings and regulatory
sanctions. These proceedings not only cost the company monetarily, but they also
affect the reputation of its brand—and most importantly, the well-being of the
consumers the company serves.

4. Economic and financial risks

GlaxoSmithKline operates in over 170 countries and is subject to political,
socioeconomic, and financial factors in individual countries as well as globally. The
company faces the adverse impact of a sustained economic downturn. Fluctuations in
foreign exchange rates and limited third-party insurance coverage also present financial
risks.

Big pharma companies like Merck (MRK), Pfizer (PFE), and Sanofi (SNY) generally
face similar risks. The Health Care Select Sector SPDR ETF (XLV) is focused on large
pharmaceutical and healthcare companies.

COST OF SHAREHOLDER EQUITY

We use CAPM, to estimate the cost of shareholder equity of GLAXOSMITHKLINE. The

CAPM formula requires only three pieces of information: the rate of return for the
general market, the beta value of the stock in question and the risk-free rate.
Interpretation
The CAPM model says that the expected return of a security or a portfolio equals the
rate on a risk-free security plus a risk premium. If this expected return does not meet or
beat the required return, then the investment should not be undertaken. The security
market line plots the results of the CAPM for all different risks (betas).

CAPM is most often used to determine what the fair price of an investment should be.
When you calculate the risky asset's rate of return using CAPM, that rate can then be
used to discount the investment's future cash flows to their present value and thus
arrive at the investment's fair value.

By extension, once calculated the investment's fair value, then compare it to its market
price. If your price estimate is higher than the market's, you could consider the stock a
bargain. If your price estimate is lower, you could consider the stock to be overvalued.

CAPM = Rf + β ( Rm – Rf )

Where RF=12.60%

Β= 0.745147

RM = 0.09 or 9%

CAPM = 12.60% +0.745 (9% - 12.60%)

= 9.918

CAPM is 9.918% and the investor anticipates a 9.918% return, the security would be
properly valued.

 If the expected return using the CAPM is higher than the investor's required
return, the security is undervalued and the investor should buy it.
 If the expected return using the CAPM is lower than the investor's required
return, the security is overvalued and should be sold.