CAPM Formula
Calculate the expected return of an investment based on its risk.
The Capital Asset Pricing Model for stock valuation.
The Formula
E(R) = R_f + β × (R_m - R_f)
CAPM calculates the expected return an investor should demand for taking on a specific level of risk. Higher risk (higher beta) means higher expected return.
Variables
| Symbol | Meaning |
|---|---|
| E(R) | Expected return of the investment |
| R_f | Risk-free rate (e.g., government bond yield) |
| β | Beta — measure of the investment's volatility relative to the market |
| R_m | Expected return of the overall market |
| R_m - R_f | Market risk premium |
Example 1
Risk-free rate = 3%, market return = 10%, stock beta = 1.5
E(R) = 3% + 1.5 × (10% - 3%)
E(R) = 3% + 1.5 × 7%
E(R) = 13.5% (higher risk demands higher return)
Example 2
A utility stock with beta = 0.6. Risk-free = 4%, market = 9%.
E(R) = 4% + 0.6 × (9% - 4%)
E(R) = 4% + 3%
E(R) = 7% (lower risk = lower expected return)
When to Use It
Use the CAPM formula when:
- Estimating the required return for a stock or portfolio
- Determining the cost of equity capital for a company
- Evaluating whether an investment is fairly priced for its risk
- Setting discount rates for NPV calculations