What it means
The familiar capital asset pricing model measures an asset's risk against the market portfolio. The consumption version swaps that benchmark for aggregate consumption, the total spending of households, on the argument that what people truly dislike is losing money when their living standards are already under pressure.
The risk measure becomes consumption beta, which captures how sensitive an asset's return is to changes in consumption growth. An asset with a high consumption beta falls just as households are cutting back, so investors demand a larger premium to hold it.
This reframing is useful because it gives a reason for premiums the market-based model struggles to explain. Assets that pay off reliably in a recession, such as high-quality government bonds, can command very low expected returns, while shares in cyclical businesses have to offer considerably more.
The practical problem is measurement. Consumption data is published with a lag, revised afterwards and smoothed by the way households actually behave, so estimated consumption betas are noisy and the model historically implies levels of risk aversion that look implausible, a gap researchers have worked on for decades.
Variants try to fix this by looking at long-run consumption growth, at the consumption of shareholders rather than all households, or at habit formation, the tendency to judge spending against what you are used to rather than in absolute terms. Each refinement improves the statistical fit without making the model easy to apply to a single company's cost of capital.
For a finance team the value is conceptual rather than computational. It is a reminder that an investment's risk depends on when its losses arrive, which is why a business whose revenue tracks discretionary consumer spending should expect a higher required return than its market beta alone suggests.
In practice
Real-world examples.
Example
A pension scheme's adviser is asked why a portfolio tilted towards consumer staples carries a lower required return than one tilted towards travel and leisure. He frames the answer in consumption terms, since the staples businesses keep earning while households cut back, so investors accept less compensation for owning them.
Example
A restaurant group's finance director challenges the 9% discount rate used in a new site appraisal. A consumption-based estimate puts the figure nearer 11% because the chain's sales track discretionary spending closely, and the committee runs the appraisal at both rates to see whether the decision actually changes.
Example
An economist explaining persistently low government bond yields to a board points out that those bonds pay out precisely when households are struggling. Under the consumption model that timing is valuable in itself, so investors will accept a very low real return for an asset that performs in a downturn.
Formula
Calculation
Expected return = Risk-free rate + Consumption beta x Consumption risk premium
An analyst is estimating the required return on a chain of mid-market restaurants, a business whose sales fall when household budgets tighten. She takes the risk-free rate as 3%, the consumption risk premium as 5% and the estimated consumption beta as 1.4, giving 3% + 1.4 x 5% = 3% + 7% = 10%. A defensive business with a consumption beta of 0.6 would come out at 3% + 0.6 x 5% = 3% + 3% = 6%. That contrast is the whole point of the model: the same market can require very different returns depending on when an asset disappoints its owners.Case study
Seen in the real world.
Harlow Leisure Group is a fictional operator of bowling centres, used here for an illustrative example. Its investment committee had appraised every new site at a single 9% discount rate for a decade, inherited from a consultant's report nobody could locate.
An analyst rebuilt the required return using a consumption-based approach, estimating a consumption beta of about 1.5 for the group's revenue because visits collapsed in the two downturns on record while grocery spending barely moved. With a 3% risk-free rate and a 5% consumption premium the required return came out near 10.5%, which turned three of the eight sites in the pipeline from marginally positive to negative.
The invented outcome was not that one rate was right and the other wrong. It was that the committee started presenting appraisals at two rates and discussing which sites survived both, which is a more honest way to handle a number nobody can measure precisely.
Watch out
Common mistakes.
- Treating consumption beta as interchangeable with market beta, when one measures sensitivity to household spending and the other to the share market.
- Using the model to produce a precise cost of capital for a single company, when the underlying consumption data is lagged, revised and far too noisy to support that.
- Reading a low required return as evidence of a better business, when it often just means the asset holds up when conditions are hard.
Questions
People also ask.
How does this differ from the standard capital asset pricing model?
The standard model measures risk against the market portfolio while this one measures it against aggregate consumption growth, so the two can rank the same asset quite differently.
Why is it rarely used in day-to-day valuation?
Because consumption betas are difficult to estimate reliably and the market-based model is far easier to support with observable data, so most practitioners stay with the familiar version.
What is the equity premium puzzle it is linked to?
It is the finding that observed share returns are much higher than consumption-based models can justify unless investors are assumed to be implausibly averse to risk, and it remains an open research question.
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