Capital Asset Pricing Model (CAPM)

CAPM starts from the idea that investors should be rewarded for taking risk, but only for risk they cannot remove by diversifying. That market-wide risk is measured by beta, which shows how much an asset tends to move when the overall market moves.

The model adds two pieces together. First, a risk-free rate, usually taken from government bond yields. Second, a risk premium, equal to beta multiplied by the market risk premium, the extra return investors expect from the stock market over the risk-free rate.

Suppose the risk-free rate is 4%, the market is expected to return 9%, so the market risk premium is 5%, and a share has a beta of 1.2. CAPM suggests an expected return of 4% plus 1.2 times 5%, which is 10%. A share with a beta of 0.8 would have an expected return of 8%.

CAPM is mainly used to estimate a company's cost of equity. It is simple and widely taught, but it relies on assumptions that do not fully hold in reality, and its inputs, especially beta and the market premium, are estimates.