Capital Asset Pricing ModelCAPM
The Capital Asset Pricing Model (CAPM) estimates the return investors should require from an asset: risk-free rate + beta × (expected market return − risk-free rate). It links expected return to market risk and is widely used to set the cost of equity.
How much return should a stock be expected to deliver? CAPM gives a simple answer: the risk-free rate, plus extra compensation for how sensitive the stock is to the overall market. Despite its simplifying assumptions, it remains the standard way analysts estimate the cost of equity. This entry explains the formula, worked examples and its criticisms.
- Category
- Fundamentals and Macroeconomics
- Reading time
- 3 min
- Also called
- CAPM formula, Capital asset pricing model formula, Security market line
- Updated
CAPM in plain words
CAPM describes the relationship between expected return and the risk of investing in a security.1
Expected return equals the risk-free rate plus beta times the market's expected return minus the risk-free rate.1
Beta and alpha are both used in CAPM to assess a portfolio's theoretical performance.2
How to apply CAPM, step by step
Risk-free rate
Usually a government bond yield. See Risk-Free Rate.
Expected market return
Long-run estimate for the market.
Market risk premium
Market return − risk-free rate. See Equity Risk Premium.
Beta
The stock's sensitivity to the market. See Beta.
Combine
Rf + β × premium.
Use the result
As a discount rate or hurdle. See Discounted Cash Flow.
Worked examples
Example 1 — Average-risk stock
9%Risk-free 4%, market return 9%, beta 1.0.
| Expected return | 4% + 1.0 × 5% = 9% |
With a beta of 1, CAPM expects the same return as the market.1
Example 2 — High-beta stock
12%Same market, beta 1.6.
| Expected return | 4% + 1.6 × 5% = 12% |
Higher beta means more market risk and a higher required return.2
Example 3 — Judging performance
+3 alphaThe beta-1.6 stock actually returns 15%.
| CAPM expected | 12% |
| Alpha | 15% − 12% = +3 points |
Returns above the CAPM expectation count as positive alpha. See Alpha.
CAPM inputs
| Aspect | Typical source | Main uncertainty |
|---|---|---|
| Risk-free rate | 10-year Treasury | Which maturity to use |
| Market premium | History or implied | Wide range of estimates |
| Beta | Regression vs an index | Unstable over time |
| Output | Cost of equity | Only as good as inputs |
How CAPM is used
Cost of equity
Discount rates in valuation. See Discounted Cash Flow.
Performance evaluation
Alpha and the Treynor ratio. See Treynor Ratio.
Project hurdle rates
Minimum acceptable returns.
Dividend models
The required return in a DDM. See Dividend Discount Model.
Advantages and disadvantages
Advantages
- Simple, widely understood.
- Links risk and return explicitly.
- Standard in corporate finance.
Disadvantages
- Assumes one risk factor (the market).
- Beta and premium estimates are unstable.
- Real returns often deviate from predictions.
Going deeper
Read as far as you need. Each level builds on the one before it.
Only market risk counts
Beginner
CAPM assumes company-specific risk can be diversified away, so only market risk (beta) earns a premium. See Systematic and Systemic Risk.
The risk premium
Intermediate
CAPM subtracts the risk-free rate from the expected market return, weights it by beta to get the risk premium, then adds the risk-free rate back.2
Beyond one factor
Advanced
Because CAPM leaves much of returns unexplained, multi-factor models add size, value, momentum and other factors. See Factor Investing.
Common mistakes
Treating output as a forecast
It is a required, not guaranteed, return.
Using stale beta
Beta changes over time.
Mismatched horizons
Match the risk-free rate to the horizon.
Ignoring other risks
Liquidity and size also matter.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- CAPM: expected return = Rf + β × (Rm − Rf).
- It prices only market risk.
- It is widely used for the cost of equity.
- Returns above CAPM are alpha.
- Inputs are uncertain estimates.
Frequently asked questions
Who developed CAPM?
Is CAPM still used?
What is the security market line?
Further learning
- Beta
The model's risk measure.
- Equity Risk Premium
The market premium input.
- Alpha
Performance beyond CAPM.
- Factor Investing
Multi-factor extensions.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Corporate Finance Institute. CAPM Formula (opens in a new tab) Checked .
- Corporate Finance Institute. Alpha (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.