Capital Asset Pricing Model (CAPM)

A method for calculating the required rate of return, discount rate or cost of capital

What is CAPM?

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between expected return and risk of a security. It shows that the return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security.

CAPM is calculated according to the following formula:

Ra = Rrf + Ba (R– Rrf)

Where:

Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return on market
Rm – Rrf = Risk Premium

The CAPM formula is used to calculate the expected return on a company’s security. It is based on the premise that investors have assumptions of systematic risk (also known as market risk or non-diversifiable risk) and need to be compensated for it in the form of a risk premium – an amount of market return greater than the risk-free rate. By investing in a risky security, investors want a higher return for taking on additional risk.

The beta is a measure of a stock’s risk (volatility), which is the fluctuation of its price relative to the market. In other words, it is the stock’s sensitivity to market risk. For instance, if a company’s beta is equal to 0, the security has no relevant risk, and its expected return should equal the risk-free rate. However, if beta is equal to 1, the expected return on a security is equal to the return on the market.

The time value of money is represented by the risk-free rate, which compensates the investor for having his money tied to the investment for a period of time. It is customarily the yield of a government bond such as a U.S. Treasury bill.

Why it’s important:

CAPM is widely use in the finance industry by various professions such as investment bankers, financial analysts and accountants. It is an integral part of the weight average cost of capital (WACC) as CAPM calculates the cost of equity. With WACC, it can be used to find the cumulative present value of the future cash flows of an investment and to further calculate its enterprise and implied equity value.