Why do we use CAPM rather than the earnings yield in computing the cost of equity in DCF? i have a vague idea why but i want to be sure.
It’s about matching cash flows to the appropriate risk profile. Earnings yield does not measure riskiness of cash flows, but the CAPM was developed to achieve just this.
CAPM is also not that good but the best we have for estimating Ke. Earnings yeild can fluctuate too much from period to period to provide a reasonable estimate of the long term equity discount rate and takes into account to many non cash items if i’m not mistaken.
My understanding is that earnings yield tells you the actual marginal cost of equity for a specific company (perhaps minus a float fee). However, it is difficult to know whether that cost is too high or too low without some external model that takes into account the riskiness of the business (and potentially the riskiness of the leverage it takes on). This is where CAPM comes in. By looking at the average of all companies’ costs of equity and comparing it to the riskiness of the market as a whole, you come up with an estimate of what that company of that degree of riskiness should be paying, and can then make a judgement about whether it is currently delivering more or less value than the average company of similar risk.