CAPM: Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM) is a formula for the return investors expect from a risky stock. That expected return is also the company's cost of equity. You start with a safe return, then add extra pay for risk, scaled by the stock's beta.
What you will learn
- What CAPM is and why its answer is called the cost of equity
- The CAPM formula: risk-free rate plus beta times the market risk premium
- How beta scales the extra return investors demand
- Why only market-wide (undiversifiable) risk gets rewarded
- Where CAPM feeds into WACC
The formula
- r_e
- cost of equity (expected return on the stock)
- R_f
- risk-free rate, e.g. government bond yield
- β
- beta, the stock's sensitivity to market moves
- R_m
- expected return on the market
- R_m − R_f
- market risk premium
Worked example
The risk-free rate is 3%, the expected market return is 8% and the stock's beta is 1.2. What is the cost of equity?
- Market risk premium = 8% − 3% = 5%
- Scale it by beta: 1.2 × 5% = 6%
- Add the risk-free rate: 3% + 6% = 9%
Answer: Cost of equity = 9%
Common questions
What is the CAPM formula?
CAPM says expected return equals the risk-free rate plus beta times the market risk premium: r_e = R_f + β × (R_m − R_f). The result is the return investors require for holding the stock, which is also the company's cost of equity.
How do you calculate cost of equity using CAPM?
Find three inputs: a risk-free rate (usually a government bond yield), the stock's beta, and the expected market return or market risk premium. Subtract the risk-free rate from the market return, multiply by beta, then add the risk-free rate back.
What does a beta of 1 mean in CAPM?
A beta of 1 means the stock tends to move in line with the overall market, so CAPM gives it the same expected return as the market. Beta above 1 means more market risk and a higher required return; below 1 means less.
Why is CAPM used in WACC?
WACC needs a cost of equity, and equity has no stated interest rate. CAPM fills that gap by estimating the return shareholders require given the stock's market risk. That number becomes the equity part of the weighted average.