CAPM (Capital Asset Pricing Model)
Cost of equity = risk-free rate + beta × equity risk premium. The most-cited model for translating systematic risk (beta) into a required return on equity.
When to use: Use to derive the discount rate (r) input for DDM, DCF, and Entry P/E formulas. CAPM gives a defensible cost-of-equity estimate that is consistent with the market's pricing of systematic risk.
Formula
Variables
| Symbol | Name | Description | Unit |
|---|---|---|---|
| ReCAPM | Cost of Equity (CAPM) | CAPM-implied required return on equity, as a decimal | % |
| Rf | Risk-Free Rate | Risk-free rate as a decimal | % |
| Beta | Beta | Stock beta vs. the market | integer |
| Rm | Market Return | Expected market return as a decimal | % |
Real-Life Examples
Example 1: Average-Beta Stock
10-year Treasury at 4%, expected market return 9%, stock beta 1.2.
Given
Step-by-Step
10% cost of equity. A stock with beta 1.2 is 20% more volatile than the market on a systematic basis, earning a 200bp premium over the market's 5% ERP. Plug 10% into Gordon, DCF, or Entry P/E as the required return.
Frequently Asked Questions
Common practice: 4-6% for US developed markets based on long-term historical data, with adjustments for current rate levels. Aswath Damodaran publishes implied ERPs based on current market valuations — typically the most-cited reference figure for academics and practitioners.
CAPM is the single-factor base. Multi-factor models add small-cap and value-premium adjustments: r = Rf + β_market × ERP + β_SMB × SMB + β_HML × HML. For most retail-investor purposes CAPM is sufficient.
Most published betas are historical regressions over 2-5 years of weekly or monthly returns. Forward-looking beta (from option prices) exists but is harder to obtain. For valuation, the historical figure is the standard input.