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The Capital Asset Pricing Model (CAPM) is a foundational equation in modern finance that describes the relationship between systematic risk and expected return for any risky asset. Developed independently by William Sharpe (1964), John Lintner (1965), and Jan Mossin (1966), it builds directly on Harry Markowitz's mean-variance portfolio theory and earned Sharpe the 1990 Nobel Prize in Economics. CAPM answers a deceptively simple question: given how much risk a stock adds to a diversified portfolio, what return should investors require to hold it? The model rests on the idea that only systematic risk — risk that cannot be diversified away because it is tied to the entire market — commands a risk premium. Company-specific risks (management failure, a product recall, a litigation loss) can be eliminated by holding many stocks, so rational investors won't be compensated for bearing them. Beta (β) is CAPM's measure of systematic risk: how much the asset moves relative to the market. A stock with β = 1.5 amplifies market swings by 50%; one with β = 0.5 moves at half the market's pace. In practice, CAPM is used in three major ways: as the cost-of-equity input in the Weighted Average Cost of Capital (WACC) for DCF valuations; as a benchmark to detect alpha (excess return above the CAPM prediction); and as a hurdle rate in capital budgeting decisions. Despite its elegance, CAPM's assumptions — frictionless markets, identical investor expectations, no taxes or transaction costs — are violated in the real world, and Fama and French (1992) showed it fails to fully explain cross-sectional stock returns. Extensions like the Fama-French three-factor and five-factor models add size, value, profitability, and investment factors to address these gaps. Nevertheless, CAPM remains the dominant model taught in finance programmes worldwide and the most common starting point for cost-of-equity estimation among practitioners.
Expected Return = Rf + β × (Rm − Rf) Equivalently: E(Ri) = Rf + βi × ERP where ERP (Equity Risk Premium) = Rm − Rf Alpha (Jensen's α) = Actual Return − [Rf + β(Rm − Rf)]
- 1Obtain the current risk-free rate: use the 10-year government bond yield in the currency of your analysis (e.g., 10-year US Treasury for USD-denominated stocks). Avoid short-term T-bills for long-term equity valuation — duration mismatch distorts the result.
- 2Find the stock's beta from a financial data provider (Bloomberg, Reuters, Yahoo Finance). Most providers use 60 months of monthly returns regressed against the local market index. Be aware that betas from different providers can differ significantly depending on the index and lookback period used.
- 3Estimate the equity risk premium (ERP). The implied ERP from market pricing (Damodaran's approach) is more forward-looking than the historical average. For the US market, a current implied ERP of 4.5–6% is common; for emerging markets, add a country risk premium.
- 4Apply the formula: E(Ri) = Rf + β × ERP. This gives the minimum return an investor should require to hold the stock in a diversified portfolio.
- 5Interpret the result: if an analyst independently forecasts the stock's expected return (e.g., from a DCF or earnings model) and finds it exceeds the CAPM expected return, the stock may offer positive alpha — potential outperformance. If below, the stock looks expensive relative to its risk.
- 6For the cost of equity in corporate finance, use CAPM to populate the Re component of WACC. Adjust beta for the company's target capital structure using the Hamada equation if the company's leverage differs from comparable firms.
Investors should require at least 12.3% to hold this tech stock given its elevated systematic risk.
A beta of 1.45 means this stock historically moves 45% more than the market on average. During a 10% market rally it might gain ~14.5%; during a 10% selloff it might fall ~14.5%. That additional volatility justifies a higher required return — 12.3% vs. 9.8% for a market-average stock (β=1).
A defensive stock with low systematic risk earns a lower required return — consistent with its role as a portfolio stabiliser.
Utility companies have regulated revenues and high dividend payout ratios, giving them low sensitivity to the economic cycle. Investors accept a lower expected return because the stock adds little volatility to a diversified portfolio. The 7.2% required return is useful as the cost of equity when valuing a utility's regulated asset base.
CAPM predicts an expected return below the risk-free rate for negatively correlated assets — they provide portfolio insurance worth paying for.
This counterintuitive result is theoretically correct: an asset that gains when markets fall provides valuable insurance to a diversified portfolio. Investors are willing to accept a return below the risk-free rate in exchange for that protection — similar to how insurance premiums are 'negative' expected value but still rational to pay.
This becomes the Re input in WACC for the retailer's DCF valuation.
Practitioners re-lever industry peer betas to match the target company's capital structure using the Hamada equation. This accounts for the additional financial risk from debt. A higher D/E ratio increases β_levered, raising the cost of equity — reflecting greater risk to equity holders from leverage.
Estimating cost of equity for inclusion in WACC for DCF valuations of public and private companies, enabling practitioners to make well-informed quantitative decisions based on validated computational methods and industry-standard approaches
Performance attribution: measuring portfolio manager alpha relative to CAPM benchmark, helping analysts produce accurate results that support strategic planning, resource allocation, and performance benchmarking across organizations, where accurate numerical computation is essential for producing reliable outputs that inform planning, evaluation, and continuous improvement processes in both corporate and individual settings
Setting project hurdle rates in corporate capital budgeting, allowing professionals to quantify outcomes systematically and compare scenarios using reliable mathematical frameworks and established formulas, demanding systematic calculation approaches that translate raw input data into actionable insights for stakeholders who depend on quantitative rigor in their daily professional activities
Regulatory allowed return on equity for utilities and infrastructure assets, supporting data-driven evaluation processes where numerical precision is essential for compliance, reporting, and optimization objectives, necessitating robust computational methods that deliver consistent and verifiable results suitable for reporting, auditing, and long-term trend analysis in professional environments
Valuing employee stock options and restricted stock grants, which requires precise quantitative analysis to support evidence-based decisions, strategic resource allocation, and performance optimization across diverse organizational contexts and professional disciplines
Emerging market stocks
For stocks in emerging markets, add a country risk premium (CRP) to the CAPM expected return: E(Ri) = Rf + β × ERP_US + CRP. Damodaran estimates CRPs from sovereign bond spreads and equity market volatility ratios. A company listed in Brazil, for example, might carry a CRP of 2–4% on top of the US ERP.
Beta instability
Beta measured over 5 years can change significantly in the following 5 years, particularly for companies undergoing strategic transformation, leverage changes, or operating in cyclical industries. Bayesian-adjusted betas (Vasicek adjustment) shrink raw betas toward the industry mean and produce more stable forecasts than raw historical betas.
Zero-beta portfolios
Fischer Black showed that if borrowing at the risk-free rate is restricted, a zero-beta portfolio (uncorrelated with the market) earns a return above the risk-free rate but below the market. This 'Black CAPM' predicts a flatter security market line, which better matches empirical data showing low-beta stocks tend to outperform CAPM predictions.
| Beta (β) | Interpretation | CAPM Expected Return | Example Asset Class |
|---|---|---|---|
| −0.2 | Strong inverse correlation | 3.2% | Some gold/volatility products |
| 0.0 | Uncorrelated to market | 4.3% | Cash, T-bills |
| 0.5 | Low systematic risk | 7.1% | Utility stocks, consumer staples |
| 1.0 | Moves with market | 9.8% | S&P 500 index fund |
| 1.3 | Moderately high risk | 11.5% | Mid-cap growth stocks |
| 1.8 | High systematic risk | 14.2% | Small-cap technology, biotech |
What is beta and how is it measured?
Beta is the slope coefficient from a linear regression of the asset's excess returns on the market's excess returns over a historical period (typically 60 months). A slope of 1.3 means for every 1% the market moves, the stock has historically moved 1.3% in the same direction on average. Different data providers produce different betas because they use different market indices, different lookback periods, and different return frequencies (daily, weekly, or monthly).
Why use the 10-year Treasury yield as the risk-free rate?
Equity analysis is long-duration — companies are expected to generate cash flows for many years. Matching duration by using a long-term bond rate avoids an artificial mismatch. The 3-month T-bill rate, while default-free, reflects short-term monetary policy rather than the long-term opportunity cost of capital relevant for equity investment decisions.
What is Jensen's alpha and how does CAPM generate it?
Jensen's alpha (α) is the difference between a portfolio's actual return and its CAPM-predicted return: α = Actual Return − [Rf + β(Rm − Rf)]. A positive alpha suggests the manager generated return above what risk alone would predict. The Sharpe ratio incorporates total risk; alpha uses only systematic risk. In efficient markets, consistent positive alpha should be near zero for most managers.
Does CAPM work in practice?
CAPM has been extensively tested and found to have significant empirical shortcomings. Fama and French (1992) showed that size (small-cap premium) and value (book-to-market premium) explain cross-sectional return differences that beta alone cannot. Momentum, quality, profitability, and investment factors have also been documented. Despite this, CAPM remains widely used because it provides a tractable, intuitive framework and the alternatives (multi-factor models) require more data and judgment.
How do I choose the equity risk premium?
There are two main approaches: historical (the average excess return of stocks over bonds over a long historical period — roughly 5–7% in the US since 1926) and implied (solving for the ERP that equates current market prices with discounted future dividends/earnings). Aswath Damodaran publishes monthly implied ERP estimates at NYU, which are widely cited in valuation practice. The implied ERP is more forward-looking and adjusts for current market conditions.
What is the difference between levered and unlevered beta?
Levered beta (equity beta) reflects both business risk and financial risk from debt. Unlevered beta (asset beta) strips out the financial risk, leaving only the underlying business risk. When benchmarking a company against peers with different capital structures, analysts unlever each peer's beta, take the median unlevered beta, then re-lever it to the target company's capital structure using the Hamada equation: β_levered = β_unlevered × [1 + (1−T) × (D/E)].
Can I apply CAPM to private companies?
Yes, with adjustments. Private companies lack observable market betas, so practitioners estimate beta from comparable public companies (unlever and re-lever as above). An additional size premium is often added for small private companies (Freeman-Reilly small-stock premium) to reflect illiquidity, limited diversification of owners, and higher information asymmetry. The Build-Up Method is an alternative that adds risk components without requiring a beta estimate.
プロのヒント
When building a DCF model, test the sensitivity of your valuation to the CAPM inputs: a 1% change in the risk-free rate or ERP can move the implied stock value by 15–25% for long-duration assets. Present your DCF with a sensitivity table showing value under different Rf and ERP combinations — this communicates valuation uncertainty honestly and is standard practice in investment banking.
ご存知でしたか？
William Sharpe initially struggled to get CAPM published. The Journal of Finance rejected his original submission, and it was only accepted after he revised it based on referee suggestions. He also had difficulty finding a dissertation supervisor willing to take on the topic — his eventual advisor, Armen Alchian, admitted he didn't fully understand the math. The paper was published in 1964 and is now one of the most cited papers in all of economics.
参考文献
- ›Sharpe WF. Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk. Journal of Finance 1964
- ›Fama EF, French KR. The Cross-Section of Expected Stock Returns. Journal of Finance 1992
- ›Damodaran A. Equity Risk Premiums (ERP): Determinants, Estimation and Implications. NYU Stern 2024
- ›CAPM — Investopedia