Capital Asset Pricing Model
- Adam Edwards
- Nov 12, 2024
- 4 min read
The Capital Asset Pricing Model (CAPM) is a formula that calculates the expected return on an investment based on its risk relative to the market. CAPM is widely used in finance to estimate the cost of equity (the return required by equity investors) and to assess the fair value of assets. It helps investors understand the relationship between risk and expected return, guiding them on whether an investment offers sufficient compensation for its risk level.
CAPM Formula
The CAPM formula is: Risk-Free Rate + β × (Market Return−Risk-Free Rate)
Where:
Risk-Free Rate: The return on a risk-free investment, typically government bonds. This represents the minimum return an investor expects with no risk.
Beta (β): A measure of the asset’s volatility relative to the overall market. Beta shows how much the asset’s price is expected to move in relation to the market:
β > 1: The asset is more volatile than the market, implying higher risk.
β < 1: The asset is less volatile than the market, implying lower risk.
Market Return: The expected return of the market as a whole, typically based on a broad market index (e.g., the FTSE 100 or S&P 500).
Market Risk Premium: (Market Return−Risk-Free Rate)(Market Return−Risk-Free Rate) is called the equity or market risk premium, representing the additional return investors require for taking on the higher risk of investing in the stock market over a risk-free asset.
Example Calculation
Suppose:
Risk-Free Rate: 2%
Market Return: 8%
Beta of the Stock: 1.5
Using the CAPM formula: 2%+1.5×(8%−2%)
Breaking it down:
Calculate the Market Risk Premium: 8%−2%=6%8%−2%=6%
Multiply the Market Risk Premium by Beta: 1.5×6%=9%1.5×6%=9%
Add the Risk-Free Rate: 2%+9%=11%2%+9%=11%
So, the expected return according to CAPM is 11%. This means that to compensate for the risk of this investment, an investor would require an 11% return.
Components of CAPM
Risk-Free Rate: This is the base return expected without any risk, often represented by government bonds due to their stability and low risk. The choice of risk-free rate depends on the investment’s time horizon; long-term investments may use long-term government bond rates.
Beta (β): Beta measures the asset’s sensitivity to market movements. A beta of:
1 means the asset’s price moves with the market.
Greater than 1 means the asset is more volatile (riskier) than the market. For example, a beta of 1.5 suggests the asset’s price will move 1.5 times the market's movement.
Less than 1 means the asset is less volatile than the market, indicating a lower risk.
Market Return - Risk-Free Rate (Market Risk Premium): This is the additional return investors expect for taking on the risk of investing in the stock market instead of a risk-free asset. It compensates for the higher risk associated with market investments.
Interpretation of CAPM
CAPM’s expected return represents the minimum return an investor should accept, given the risk associated with the asset. This makes CAPM useful for:
Evaluating Potential Investments: If an investment’s actual or estimated return is above the CAPM-calculated expected return, it may be considered attractive, as it offers a higher return for its risk.
Calculating Cost of Equity: Companies use CAPM to determine their cost of equity, which is the return required by shareholders. It’s essential for calculating Weighted Average Cost of Capital (WACC) and for valuation in discounted cash flow (DCF) models.
Assessing Risk-Adjusted Performance: CAPM allows investors to compare investments with different risk levels by adjusting returns for risk, making it easier to assess if returns are justified by the asset’s volatility.
Advantages of CAPM
Simplicity: CAPM offers a straightforward way to estimate expected returns based on risk.
Standardised Approach: CAPM provides a consistent framework to compare returns for assets with different risk levels.
Widely Used: CAPM is a standard in finance for calculating the cost of equity and assessing whether an investment’s return compensates for its risk.
Limitations of CAPM
Assumptions of a Risk-Free Rate and Beta: CAPM assumes a stable risk-free rate and beta, which may not reflect actual market conditions. Market conditions can shift quickly, affecting both the risk-free rate and the stock’s beta.
Historical Beta and Market Return: CAPM often relies on historical beta and market return, assuming they will predict future performance. However, past performance is not always a reliable indicator of future results.
Market Efficiency Assumption: CAPM assumes that all investors have the same information and expectations and that markets are efficient, which isn’t always realistic.
Single Factor Model: CAPM considers only one factor—market risk—as the basis for expected returns. In reality, multiple factors (e.g., interest rates, company-specific risk) influence returns.
CAPM in Practice
Investment Evaluation: CAPM helps investors decide whether an asset’s return justifies its risk. By calculating the expected return, CAPM allows investors to assess if they’re being adequately compensated for the risk.
Capital Budgeting and Corporate Finance: Companies use CAPM to calculate their cost of equity, a crucial component of WACC. WACC is then used as a discount rate in DCF models for investment appraisals and valuations.
Portfolio Management: CAPM helps portfolio managers allocate assets based on risk-adjusted returns. By comparing expected returns calculated with CAPM, they can determine if an asset is undervalued or overvalued relative to its risk.
In summary
CAPM is a foundational model in finance for understanding the relationship between risk and return. It helps investors and companies calculate expected returns based on an asset’s volatility relative to the market, providing a benchmark for assessing investment opportunities. Despite its limitations, CAPM remains a valuable tool in corporate finance and investment analysis.