what is the capital asset pricing model

The Capital Asset Pricing Model, or CAPM, is a formula that estimates the return an investor should require from a stock given its risk. It says the required return equals the risk-free rate plus the stock’s beta multiplied by the equity risk premium — the extra return the market as a whole pays over the risk-free rate. The idea is that investors must be compensated for the risk they cannot diversify away, and a stock’s beta measures how much of that market risk it carries. CAPM is the standard way to turn a company’s riskiness into a single required return, or cost of equity.

how do you calculate the cost of equity

Using CAPM, the cost of equity is the risk-free rate plus beta times the equity risk premium. For example, with a 6% risk-free rate, a beta of 1.2 and a 7% equity risk premium, the cost of equity is 6% + 1.2 × 7% = 14.4%. The risk-free rate comes from a government bond yield, the beta from how the stock has moved relative to the market, and the equity risk premium from the long-run extra return equities have paid over bonds. That 14.4% is then the rate you would use to discount the company’s future cash flows or dividends.

why is the equity risk premium so hard to pin down in capm

In CAPM the equity risk premium is the term multiplied by a stock’s beta, so it directly scales the reward for risk — yet it cannot be observed directly and must be estimated, which is why it is contentious. Some derive it from long-run historical returns of equities over bonds, others from forward-looking models of expected returns, and reasonable estimates for India span a range rather than a single agreed figure. Because two analysts can plug in different premiums, they can compute quite different costs of equity for the very same stock, which is a key reason CAPM outputs should be treated as ranges rather than precise numbers.

why does a higher beta mean a higher required return

Beta measures how much a stock amplifies the market’s moves — a beta of 1.5 means it tends to rise and fall about 1.5 times as much as the market. In CAPM, more of that non-diversifiable risk means an investor should demand more return to hold it, so a higher beta pushes the cost of equity up. A high-beta stock therefore has to clear a higher bar: its expected returns must be greater to justify the extra volatility it forces on a portfolio, and in a valuation its cash flows are discounted more harshly.

CAPM and cost of equity: how to calculate the required return

Every valuation model that discounts future cash — a DCF, a dividend discount model, a reverse DCF — needs one crucial input: the rate at which to discount. For equity, that rate is the cost of equity, the return investors require to hold the stock given its risk. The Capital Asset Pricing Model is the standard machine for turning a company’s riskiness into that single number.

Required return = risk-free + beta × risk premium

CAPM says the return you should demand from a stock is the risk-free rate (what a government bond pays for near-zero risk) plus a reward for the risk you cannot diversify away. That reward is the stock’s beta — how much it amplifies the market’s swings — multiplied by the equity risk premium, the extra return equities pay over bonds. A stock that moves with the market has a beta of 1; one that swings harder has a beta above 1 and therefore a higher required return.

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Set the risk-free rate, the beta and the equity risk premium, and watch the cost of equity move — then push beta up and see how much harder a volatile stock’s cash flows get discounted.

Worked example

Cost of equity for a beta-1.2 stock

Risk-free 6%, ERP 7%

Risk-free rateA government bond yield6%

BetaSwings ~1.2× the market1.2

Equity risk premiumExtra return for equity risk7%

Cost of equityThe required return6% + 1.2 × 7% = 14.4%

If beta were 1.6More risk, higher bar17.2%

The same market gives a beta-1.2 stock a 14.4% required return and a beta-1.6 stock a 17.2% one — the riskier stock must clear a higher bar. That number is exactly what you feed into a DCF or dividend discount model as the discount rate, which is why a small change in it moves a valuation so much.

Check yourself

Two stocks sit in the same market. Stock A has a beta of 0.8; Stock B has a beta of 1.6. What does CAPM say about their required returns?

Simple bhasha mein

Risk ka daam

Kisi bhi valuation mein cash ko aaj ki value mein laane ke liye ek rate chahiye — equity ke liye woh cost of equity hai. CAPM: risk-free + beta × equity risk premium. 6% + 1.2×7% = 14.4%. Zyada beta (zyada jhoola) matlab zyada return maango, matlab uski cash sakhti se discount hoti hai — keemat kam. Par beta aur premium dono andaaze hain, fact nahi — Indian stock pe rupee wala risk-free (G-sec) lo, US ka nahi. Ek range mein chalao, ek number pe bharosa mat karo.

What to remember

The cost of equity is the discount rate every equity valuation needs.
CAPM sets it as: risk-free rate + beta × equity risk premium.
A higher beta means more non-diversifiable risk and a higher required return.
Beta and the equity risk premium are estimates, so the output is an assumption, not a fact.
Use rupee inputs for Indian stocks, and run valuations across a range of costs of equity.

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Common questions

Short, direct answers to what people ask about this topic.

what is the capital asset pricing model: The Capital Asset Pricing Model, or CAPM, is a formula that estimates the return an investor should require from a stock given its risk. It says the required return equals the risk-free rate plus the stock’s beta multiplied by the equity risk premium — the extra return the market as a whole pays over the risk-free rate. The idea is that investors must be compensated for the risk they cannot diversify away, and a stock’s beta measures how much of that market risk it carries. CAPM is the standard way to turn a company’s riskiness into a single required return, or cost of equity.
how do you calculate the cost of equity: Using CAPM, the cost of equity is the risk-free rate plus beta times the equity risk premium. For example, with a 6% risk-free rate, a beta of 1.2 and a 7% equity risk premium, the cost of equity is 6% + 1.2 × 7% = 14.4%. The risk-free rate comes from a government bond yield, the beta from how the stock has moved relative to the market, and the equity risk premium from the long-run extra return equities have paid over bonds. That 14.4% is then the rate you would use to discount the company’s future cash flows or dividends.
why is the equity risk premium so hard to pin down in capm: In CAPM the equity risk premium is the term multiplied by a stock’s beta, so it directly scales the reward for risk — yet it cannot be observed directly and must be estimated, which is why it is contentious. Some derive it from long-run historical returns of equities over bonds, others from forward-looking models of expected returns, and reasonable estimates for India span a range rather than a single agreed figure. Because two analysts can plug in different premiums, they can compute quite different costs of equity for the very same stock, which is a key reason CAPM outputs should be treated as ranges rather than precise numbers.
why does a higher beta mean a higher required return: Beta measures how much a stock amplifies the market’s moves — a beta of 1.5 means it tends to rise and fall about 1.5 times as much as the market. In CAPM, more of that non-diversifiable risk means an investor should demand more return to hold it, so a higher beta pushes the cost of equity up. A high-beta stock therefore has to clear a higher bar: its expected returns must be greater to justify the extra volatility it forces on a portfolio, and in a valuation its cash flows are discounted more harshly.

CAPM: the price of risk, and your cost of equity

Required return = risk-free + beta × risk premium

Common questions