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.
CAPM explained simply
CAPM says the return investors require from a stock equals a safe return plus extra pay for market risk: cost of equity = risk-free rate + beta × (market return − risk-free rate). With a 3% risk-free rate, a beta of 1.2 and an 8% market return, the cost of equity is 9%.
What this CAPM lesson covers
- 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
CAPM formula, explained
- 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
How to calculate cost of equity with CAPM (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%
CAPM vs APT: what's the difference?
| CAPM | APT (Arbitrage Pricing Theory) | |
|---|---|---|
| Risk factors | One: the overall market | Several: e.g. inflation, interest rates, GDP |
| Sensitivity measure | One beta | One beta per factor |
| Main use | Cost of equity for WACC and valuation | Explaining returns with several macro risks |
| Ease of use | Simple, three inputs | Harder: you must choose the factors |
Is CAPM actually right? David's take
CAPM is brilliant reasoning inside a given set of variables. The trouble is picking the variables. Beta comes from past prices, the market premium is an estimate, and the 'risk-free' rate depends on which bond you choose. Move beta from 1.2 to 0.9 and the same company's cost of equity drops from 9% to 7.5%. My concept 'High IQ, Wrong Variables' says smart people reason perfectly within their variables but are poor at choosing which ones matter: official facts versus de facto facts. Learn CAPM for the exam and to speak the language. Just don't treat a two-decimal answer as the truth.
From David's concept: High IQ, Wrong Variables. This is David's opinion, alongside the standard textbook answer above.
Harder CAPM questions
How do you estimate beta for a private company with no share price?
Borrow betas from similar listed companies, strip out their debt, then add back yours. Example: a peer has beta 1.3 with debt/equity 0.5 and a 25% tax rate. Unlevered beta = 1.3 ÷ (1 + 0.75 × 0.5) ≈ 0.95. Your company has debt/equity 0.2, so relevered beta = 0.95 × (1 + 0.75 × 0.2) ≈ 1.09. With a 3% risk-free rate and a 5% market premium, cost of equity ≈ 3% + 1.09 × 5% ≈ 8.4%. Practitioners often add a premium for small size or illiquidity on top.
Which risk-free rate should I use: a 3-month T-bill or a 10-year government bond?
Match the horizon of what you're valuing. For long-lived projects and company valuations, most practitioners use a long-term government bond yield (often 10-year), not a short-term bill. In a country whose government bonds carry default risk, analysts usually start from a safer benchmark and add a country risk premium.
What if CAPM gives a cost of equity lower than the company's cost of debt?
Treat it as a warning sign, not an answer. Shareholders are paid after lenders, so equity should cost more than debt. A very low beta or stale inputs are the usual cause; re-check the beta with peer companies before using the number.
Common CAPM 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.