This equation is similar to CAPM while the profitability is based on the profitability of the firms in the market and the profitability of the asset. This might be more realistic model as it is dependent on profitability rather than movement of stock with respect to market and also include the impact of factors impacting the profitability which otherwise were part of assumptions. However the issues of identifying the right number of firms and expected profitability of all the firms. Further studies show that the issues with CAPM may be resolved by incorporating more usage of data in the CAPM model. The modifications that are suggested in the CAPM are (Damodaran, 2011)
Multi Beta Models: This model provides different beta values related to macroeconomic variables including interest rate, yield curve and the GDP growth rate. This is extension of CAPM model replacing the single market beta. .
Market Price Based Models: The beta calculated by the CAPM is based on the correlation of the stock and the market, standard deviation of stock and standard deviation of market. The correlation factor is highly unstable and varies too much over the period. The market price based models considers dispensing of the correlation factor by estimation of the relative risk associated with stock. This is done by division of stock standard deviation by average standard deviation of all the stocks.
Accounting Information Based Models: This is the model that has been discussed above i.e. accounting based risk measurement. This is called accounting beta. Another method to use accounting information based model is creation of scaled risk measurement with respect to certain accounting ratio that is important from the viewpoint of the asset.
In the study conducted by Knox (2011), the validity of CAPM is tested for the stock performance of ten stocks is estimated based on the data of past twenty five years. This experiment was to test the school of thoughts associated with CAPM i.e.
Use of more data will improve the validity of CAPM
Use of too old data isn’t useful as companies witness major shifts and trends in business.