The CAPM is an elementary model of the risk premium or return a stock earns above a risk free rate. It measures the stock’s performance relative to a benchmark such as the S&P 500 or the Russell 2000. This model is used to calculate a stocks Beta. A stock with a Beta of one moves in lock step with the market. A stock with a Beta of 1.6 or more is a lot more volatile. A stock with a negative Beta is counter-cyclical, meaning that it moves opposite to the market.
A factor model builds on the CAPM. A factor model may look at other macroeconomics factors such as inflation, the interest rate and other macroeconomic indicators. A company specific factor model would look at company specific factors such as: earnings, P/E, ROE, ROA, ROIC.** If we develop a company specific factor model of the risk premium that includes these variables among other significant variables, we should be able to identify company specific traits with explanatory power.
Controlling for these variables we could then look at the effect of environmental litigation on a company’s risk premium, in essence the return to its shareholders. This information would be interesting in determining if litigation serves as a deterrent or if it is just a nuisance. Is the presence of litigation enough to provide an incentive for firms to correct actions?
A current example would be Transocean, the owner of the Deepwater Horizon which was at the heart of the BP oil spill last year. TransOcean’s stock price dropped in the days following the BP oil spill, although, BP and its minority partner assumed the risk of the deep water operation. RIG was a contractor. It would be interesting to see how litigation affects TransOcean’s returns to its shareholders and how that plays out in the aftermath of the BP oil spill.
P/E: Price to earnings.
ROE: Return on equity.
ROA: Return on assets.
ROIC: Return on invested