CAPM (Capital Asset Pricing Model)

Valuation Model Investment Wiki — Fundamentals
The Capital Asset Pricing Model (CAPM) mathematically describes the relationship between systematic risk and expected return for assets, particularly equities. It dictates exactly how much return a rational investor should demand for absorbing the risk of a specific stock over a risk-free bond.
Quick Reference
Type Valuation Model
Formula Risk-Free Rate + Beta(Market Return - Risk-Free Rate)
Main Output Expected Return (Cost of Equity)

1.0 The Formula

Basic Form

formulaEr = Rf + β(Rm - Rf)

Where:
Er = Expected Return of the investment
Rf = Risk-Free Rate (usually the 10-Year US Treasury yield)
β = Beta of the investment (Volatility)
Rm = Expected return of the total market
(Rm - Rf) = Equity Market Premium

CAPM states that if you park cash in a risk-free Treasury, you earn `Rf`. If you buy an index fund (Beta = 1), you earn the Equity Risk Premium `(Rm - Rf)`. Therefore, if you buy a stock heavily volatile (Beta = 2), you should mathematically demand twice the equity risk premium.

If a stock's historical actual return is higher than the CAPM expected return, it has generated "Alpha".

3.0 Related Pages

Beta

The core risk multiplier inside the CAPM equation.

WACC

CAPM provides the "Cost of Equity" value that plugs directly into the WACC formula for DCF models.