Calculate the expected return of a stock using the Capital Asset Pricing Model from risk-free rate, beta, and market return.
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Investment Theory
The Capital Asset Pricing Model (CAPM) calculates the expected return of an asset based on its systematic risk (beta) relative to the overall market. It is one of the most widely used models in finance for pricing risky securities and estimating the cost of equity.
CAPM links expected return to systematic (non-diversifiable) risk. The model assumes investors are compensated only for bearing market risk, not for idiosyncratic risk that can be diversified away.
The model provides a benchmark expected return: if an asset’s actual expected return exceeds the CAPM prediction, it plots above the Security Market Line (SML) and may be undervalued.
The CAPM equation has three inputs.
E(Ri) = Rf + βi × (E(Rm) − Rf)
Rf = risk-free rate, βi = asset beta, E(Rm) = expected market return, (E(Rm) − Rf) = equity risk premium.
Risk-free rate 4.5%, beta 1.2, expected market return 10%. ERP = 10% − 4.5% = 5.5%. Expected return = 4.5% + 1.2 × 5.5% = 11.1%.
CAPM assumes markets are efficient, investors are rational mean-variance optimisers, and there are no taxes or transaction costs. Beta is estimated from historical data and may not persist. The equity risk premium is debated and varies by estimation method (historical average, survey-based, implied from market prices).
Frequently asked questions
The yield on a government bond matching the investment horizon — typically the 10-year US Treasury for equity analysis. For shorter horizons, use 3-month T-bills.
Historical US equity risk premiums range from 4% to 7% depending on the measurement period. Damodaran’s annually updated estimates are widely used in practice.
Beta measures the sensitivity of an asset’s returns to market returns. Beta > 1 means the asset amplifies market moves; beta < 1 means it dampens them; beta = 0 means no market sensitivity.
It provides a simple, intuitive framework and is the standard benchmark in corporate finance, regulation, and valuation. More complex models (Fama-French 3-factor, APT) exist but require more inputs and are harder to implement.
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