CAPM
TheoryDefinition
The Capital Asset Pricing Model is the most-taught theory of how risk gets priced into stock returns. It says: the return you should expect from any single stock equals the risk-free rate, plus that stock's sensitivity to the market (its beta) times the extra return investors demand for holding stocks instead of cash (the market risk premium).
Plain English: a stock with beta 1.0 should earn whatever the market earns. A stock with beta 2.0 should earn twice the market's premium over cash (because it swings twice as hard). A stock with beta 0.5 should earn half. The risk-free rate (T-bills) is the floor every investment must clear.
CAPM is more useful as a mental model than as a precise number. Real-world stock returns deviate from what CAPM predicts — that's where the factor premia story comes in. But it remains the starting point for cost-of-equity calculations in DCF, the basis for Sharpe ratios, and the foundation of modern portfolio theory.
Plain English: a stock with beta 1.0 should earn whatever the market earns. A stock with beta 2.0 should earn twice the market's premium over cash (because it swings twice as hard). A stock with beta 0.5 should earn half. The risk-free rate (T-bills) is the floor every investment must clear.
CAPM is more useful as a mental model than as a precise number. Real-world stock returns deviate from what CAPM predicts — that's where the factor premia story comes in. But it remains the starting point for cost-of-equity calculations in DCF, the basis for Sharpe ratios, and the foundation of modern portfolio theory.
How it works
Try the model — drag the sliders
Expected return =
4.0% + 1.00 × (10.0% − 4.0%)
=
10.0%
The olive line is the Security Market Line — the relationship CAPM predicts between beta and expected return. Stocks above the line have outperformed CAPM (positive alpha); below, underperformed.
Formula
E(R) = Rf + β × (Rm − Rf)
Example
Risk-free rate: 4.0% (3-mo T-bill). Market expected return: 10% (S&P long-run). Market risk premium: 6%.
• Apple (β ≈ 1.2): Expected return = 4 + 1.2 × 6 = 11.2%
• Coca-Cola (β ≈ 0.6): Expected return = 4 + 0.6 × 6 = 7.6%
• Tesla (β ≈ 2.0): Expected return = 4 + 2.0 × 6 = 16.0%
Drag the sliders below to play with the inputs and see how they shift each stock's expected return on the Security Market Line.
• Apple (β ≈ 1.2): Expected return = 4 + 1.2 × 6 = 11.2%
• Coca-Cola (β ≈ 0.6): Expected return = 4 + 0.6 × 6 = 7.6%
• Tesla (β ≈ 2.0): Expected return = 4 + 2.0 × 6 = 16.0%
Drag the sliders below to play with the inputs and see how they shift each stock's expected return on the Security Market Line.
Related tool
Open the stockpitch tool on Arsenal.finance →