The Capital Asset Pricing Model (CAPM), Explained

The capital asset pricing model (CAPM) is a financial model used to estimate an investment’s expected return based on its exposure to market risk. CAPM calculates expected return using three components: the risk-free rate, the investment’s beta and the expected market risk premium. Investors and financial professionals can use the model to evaluate whether an investment’s potential return is consistent with the amount of systematic risk it carries.

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What Is the Capital Asset Pricing Model (CAPM)?

The capital asset pricing model (CAPM) is widely used in finance to estimate the return investors may require for taking on an investment’s systematic risk. The model is based on the concept that investors require higher expected returns for taking on greater systematic risk, which cannot be eliminated through diversification.

Expected return = Risk-free rate + (beta x market risk premium)

Using CAPM, the expected return represents the rate of return associated with an investment’s level of systematic risk. In valuation, that expected return can also serve as a discount rate for estimating the present value of future cash flows. It is a discount rate an investor can use in determining the value of an investment.

The risk-free rate represents the return available on an investment assumed to have no default risk. Treasury securities are commonly used as a proxy, with the maturity generally chosen to correspond to the investment or valuation horizon.

Beta is a measure of a stock’s market risk, expressed as a numerical value that indicates how sensitive the stock has historically been to movements in the broader market. A beta above 1 means the stock has tended to move more than the market, while a beta below 1 means it has tended to move less. A beta of 1 indicates that the stock has generally moved in line with the market.

Lastly, the market risk premium is the difference between the market’s expected return and the risk-free rate. It represents the additional return investors expect in return for assuming the systematic risk associated with investing in the market rather than a risk-free asset.

CAPM provides a way to estimate the return associated with an investment’s level of systematic risk, which investors and analysts can use when evaluating securities.

Breaking Down the CAPM Formula

Imagine that you are looking at a stock worth $50 per share today with a beta of 1.5, giving it greater systematic risk than the overall market. Also, assume that the risk-free rate is 3% and this investor expects the market to return 5% per year.

The expected return of the stock based on CAPM is 6%.

6% = 3% + 1.5 x (5%-3%)

The 6% expected return can serve as the required return on the stock when estimating its value. For example, an investor could use that rate as a discount rate when calculating the present value of expected future cash flows. If that valuation produces a value of $50 per share, it would be consistent with the stock’s current $50 market price under those assumptions.

History of CAPM

Economist William Sharpe developed one of the foundational versions of CAPM in research published in the Journal of Finance in 1964, building on Harry Markowitz’s earlier work on portfolio theory. Other economists, including John Lintner and Jan Mossin, independently developed similar models around the same period. Sharpe later received the 1990 Nobel Memorial Prize in Economic Sciences for his contributions to financial economics.

Sharpe noted that an individual investment contains two kinds of risk:

Systematic Risk: In other words, market risk that portfolio diversification can’t reduce. Interest rates, recessions and major geopolitical events are examples of systematic risks.
Unsystematic Risk: This “specific risk” relates to a specific company or industry. Strikes, mismanagement or shortage of a necessary component in the manufacturing process all qualify as unsystematic risk.

Unsystematic risk is what modern portfolio theory targets when it suggests diversification of a portfolio. However, diversification doesn’t address systematic risk. CAPM uses beta to account for systematic risk when estimating an investment’s expected return.

Pros and Cons of CAPM

SmartAsset: The Capital Asset Pricing Model (CAPM), Explained

The capital asset pricing model is important in the world of financial modeling for a few key reasons. First, by estimating the return associated with an investment’s systematic risk, CAPM can give investors and analysts a benchmark for evaluating potential investments.

Second, it’s a relatively simple formula that’s fairly easy to use. Additionally, the CAPM is an important tool for investors when it comes to assessing both risk and reward. It’s also one of the few formulas that accounts for systematic risk.

That said, CAPM’s critics say it makes unrealistic assumptions. For instance, beta also has limitations as a measure of risk. It is typically estimated using historical price movements and may not fully capture an investment’s future risk or the different ways investors perceive potential losses.

Meanwhile, CAPM also assumes a theoretical market portfolio containing all risky assets. In practice, analysts generally use a broad market index as a proxy, which may not perfectly represent the market portfolio envisioned by the model.

Bottom Line

The capital asset pricing model provides a relatively simple way to estimate an investment’s expected return based on its exposure to systematic risk. However, CAPM relies on several simplifying assumptions and beta does not capture every source of investment risk. Investors and analysts may therefore use CAPM alongside other valuation and risk-analysis methods when evaluating securities.

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