What Is the Capital Asset Pricing Model (CAPM)?
The capital asset pricing model links the return an investor should demand from a security to that security's exposure to market-wide risk. Its central insight is that investors are only compensated for systematic risk, the risk that cannot be diversified away, because company-specific risk can be eliminated by holding a diversified portfolio.
In practice, CAPM is the workhorse for estimating the cost of equity, which then feeds into WACC and discounted cash flow valuations.
Formula
The formula is Expected Return = Rf + Beta x (Rm - Rf), where Rf is the risk-free rate, Beta measures the stock's sensitivity to market movements, and (Rm - Rf) is the equity risk premium, the excess return of the market over the risk-free rate.
The risk-free rate is usually taken from a long-term government bond such as the 10-year Treasury, beta is estimated from historical regressions or derived from comparable companies, and the equity risk premium is typically assumed to be around 4% to 6% based on long-run historical data.
Example
Assume the risk-free rate is 4%, the equity risk premium is 5%, and a stock has a beta of 1.4. CAPM gives an expected return of 4% + 1.4 x 5% = 4% + 7% = 11%. A defensive stock with a beta of 0.7 would instead require only 4% + 0.7 x 5% = 7.5%, showing how riskier stocks must promise higher returns to attract investors.
Why It Matters
CAPM provides a disciplined, widely accepted way to price risk, which is why it underpins cost of equity estimates in nearly every DCF, fairness opinion, and corporate capital budgeting exercise. Despite academic criticism that beta imperfectly captures real-world risk, no alternative has displaced it in day-to-day banking practice.
Interviewers often ask you to state the CAPM formula and explain each input, so knowing where the risk-free rate, beta, and equity risk premium come from is table stakes.
