By WILL KENTON

Updated October 24, 2022

Reviewed by JULIUS MANSA

Fact checked by SUZANNE KVILHAUG

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, or the general perils of investing, and expected return for assets, particularly stocks.1 It is a finance model that establishes a linear relationship between the required return on an investment and risk. The model is based on the relationship between an asset's beta, the risk-free rate (typically the Treasury bill rate), and the equity risk premium, or the expected return on the market minus the risk-free rate.

CAPM evolved as a way to measure this systematic risk. It is widely used throughout finance for pricing risky securities and generating expected returns for assets, given the risk of those assets and cost of capital.Understanding the Capital Asset Pricing Model (CAPM)

The formula for calculating the expected return of an asset, given its risk, is as follows:1

\begin{aligned} &ER_i = R_f + \beta_i ( ER_m - R_f ) \\ &\textbf{where:} \\ &ER_i = \text{expected return of investment} \\ &R_f = \text{risk-free rate} \\ &\beta_i = \text{beta of the investment} \\ &(ER_m - R_f) = \text{market risk premium} \\ \end{aligned}​ERi​=Rf​+βi​(ERm​−Rf​)where:ERi​=expected return of investmentRf​=risk-free rateβi​=beta of the investment(ERm​−Rf​)=market risk premium​

Investors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared with its expected return. In other words, by knowing the individual parts of the CAPM, it is possible to gauge whether the current price of a stock is consistent with its likely return.

The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium, which is the return expected from the market above the risk-free rate. The risk-free rate is then added to the product of the stock’s beta and the market risk premium. The result should give an investor the required return or discount rate that they can use to find the value of an asset.

For example, imagine an investor is contemplating a stock valued at $100 per share today that pays a 3% annual dividend. Say that this stock has a beta compared with the market of 1.3, which means it is more volatile than a broad market portfolio (i.e., the S&P 500 index). Also, assume that the risk-free rate is 3% and this investor expects the market to rise in value by 8% per year.

The expected return of the stock based on the CAPM formula is 9.5%:

\begin{aligned} &9.5\% = 3\% + 1.3 \times ( 8\% - 3\% ) \\ \end{aligned}​9.5%=3%+1.3×(8%−3%)​

The expected return of the CAPM formula is used to discount the expected dividends and capital appreciation of the stock over the expected holding period. If the discounted value of those future cash flows is equal to $100, then the CAPM formula indicates the stock is fairly valued relative to risk.

Several assumptions behind the CAPM formula have been shown not to hold up in reality. Modern financial theory rests on two assumptions:

1. Securities markets are very competitive and efficient (that is, relevant information about the companies is quickly and universally distributed and absorbed).

2. These markets are dominated by rational, risk-averse investors, who seek to maximize satisfaction from returns on their investments.

By WILL KENTON

Updated October 24, 2022

Reviewed by JULIUS MANSA

Fact checked by SUZANNE KVILHAUG

The Capital Asset Pricing Model (CAPM) describes the relationship between systematic risk, or the general perils of investing, and expected return for assets, particularly stocks.1 It is a finance model that establishes a linear relationship between the required return on an investment and risk. The model is based on the relationship between an asset's beta, the risk-free rate (typically the Treasury bill rate), and the equity risk premium, or the expected return on the market minus the risk-free rate.

CAPM evolved as a way to measure this systematic risk. It is widely used throughout finance for pricing risky securities and generating expected returns for assets, given the risk of those assets and cost of capital.Understanding the Capital Asset Pricing Model (CAPM)

The formula for calculating the expected return of an asset, given its risk, is as follows:1

\begin{aligned} &ER_i = R_f + \beta_i ( ER_m - R_f ) \\ &\textbf{where:} \\ &ER_i = \text{expected return of investment} \\ &R_f = \text{risk-free rate} \\ &\beta_i = \text{beta of the investment} \\ &(ER_m - R_f) = \text{market risk premium} \\ \end{aligned}​ERi​=Rf​+βi​(ERm​−Rf​)where:ERi​=expected return of investmentRf​=risk-free rateβi​=beta of the investment(ERm​−Rf​)=market risk premium​

Investors expect to be compensated for risk and the time value of money. The risk-free rate in the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared with its expected return. In other words, by knowing the individual parts of the CAPM, it is possible to gauge whether the current price of a stock is consistent with its likely return.

The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio.

A stock’s beta is then multiplied by the market risk premium, which is the return expected from the market above the risk-free rate. The risk-free rate is then added to the product of the stock’s beta and the market risk premium. The result should give an investor the required return or discount rate that they can use to find the value of an asset.

For example, imagine an investor is contemplating a stock valued at $100 per share today that pays a 3% annual dividend. Say that this stock has a beta compared with the market of 1.3, which means it is more volatile than a broad market portfolio (i.e., the S&P 500 index). Also, assume that the risk-free rate is 3% and this investor expects the market to rise in value by 8% per year.

The expected return of the stock based on the CAPM formula is 9.5%:

\begin{aligned} &9.5\% = 3\% + 1.3 \times ( 8\% - 3\% ) \\ \end{aligned}​9.5%=3%+1.3×(8%−3%)​

The expected return of the CAPM formula is used to discount the expected dividends and capital appreciation of the stock over the expected holding period. If the discounted value of those future cash flows is equal to $100, then the CAPM formula indicates the stock is fairly valued relative to risk.

Several assumptions behind the CAPM formula have been shown not to hold up in reality. Modern financial theory rests on two assumptions:

1. Securities markets are very competitive and efficient (that is, relevant information about the companies is quickly and universally distributed and absorbed).

2. These markets are dominated by rational, risk-averse investors, who seek to maximize satisfaction from returns on their investments.