19 Nov, 2025
4 mins read
The Capital Asset Pricing Model (CAPM) is one of the most widely used financial models for estimating the expected return on an investment. Traders, portfolio managers, and analysts rely on it to understand how much return an asset should ideally generate based on its risk. By linking risk to reward in a structured way, CAPM helps investors make more rational and consistent decisions.
Below, we break down what the model means, how it works, the CAPM formula, a simple example, and where it fits in real-world investing.
The Capital Asset Pricing Model explains the relationship between expected return and the systematic risk of a security. Systematic risk refers to market-wide movements that affect all stocks, such as economic cycles, inflation changes, or geopolitical events.
In simple terms:
CAPM tells you what return you should expect from an investment, given how volatile it is relative to the market (its beta).
The model is widely used in valuation, portfolio construction, equity research, and estimating the cost of equity for companies.
The formula for CAPM is:
Expected Return (Re) = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate)
Where:
Risk-Free Rate – usually the yield on government securities.
Beta (β) – measures how sensitive a stock is to market movements.
Market Return – expected return of the overall market.
Market Risk Premium (MRP) – Market Return minus the Risk-Free Rate.
This formula helps investors evaluate whether a stock is fairly valued or overpriced based on its risk level.
Let’s use a simple example of CAPM to understand how the formula works.
Assume:
Risk-Free Rate = 6%
Market Return = 12%
Beta of the stock = 1.2
Market Risk Premium = 12% – 6% = 6%
Expected Return = 6% + 1.2 × 6%
= 6% + 7.2%
= 13.2%
Interpretation:
Based on its risk level (beta of 1.2), the stock should ideally offer a return of 13.2%. If analysts expect the stock to generate only 10%, it may be undervaluing risk. If it offers 18%, it might be overvalued or truly outperforming.
The Capital Asset Pricing Model is used across several areas of finance:
Investors use CAPM to estimate expected returns from various assets and create portfolios that match their risk preferences.
Equity analysts use CAPM while calculating the discount rate (cost of equity) in models such as the DCF (Discounted Cash Flow).
Portfolio managers compare actual returns to CAPM-predicted returns to check whether they have generated true alpha.
CAPM helps distinguish between diversifiable risk and market-wide risk.
CAPM remains widely used because of several advantages:
The model is easy to understand and implement.
It highlights that only market-wide risk (beta) should drive return expectations, not company-specific fluctuations.
CAPM is a standard for calculating the cost of equity in corporate finance and valuation.
Investors can evaluate if they are being compensated fairly for the risk they take.
Despite its popularity, CAPM has limitations:
Beta is backward-looking and may not predict future behavior accurately.
The model assumes no taxes, no transaction costs, and equal access to information — unrealistic in real markets.
Different analysts may use different benchmarks, leading to inconsistent results.
Investor sentiment, liquidity shocks, and irrational market behavior are not captured by CAPM.
|
Model |
What It Measures |
Key Strength |
|---|---|---|
|
CAPM |
Expected return based on market risk (beta) |
Simple, widely accepted |
|
APT (Arbitrage Pricing Theory) |
Multi-factor return model |
More flexible than CAPM |
|
Dividend Discount Model (DDM) |
Intrinsic value based on dividends |
Effective for dividend-paying stocks |
|
Fama-French Model |
Return based on size and value factors |
More realistic in modern markets |
While CAPM provides a clean and intuitive baseline, advanced models may offer deeper insights depending on the asset class.
The model works based on some strong assumptions:
Investors are rational and risk-averse
All participants have equal access to information
Investors can borrow and lend at the risk-free rate
Markets are efficient
All investors hold diversified portfolios
While these assumptions simplify the model, they may limit accuracy in real-world conditions.
The Capital Asset Pricing Model (CAPM) remains one of the foundational tools in modern finance. Whether you're estimating expected returns, valuing stocks, or building a portfolio, CAPM provides a structured way to connect risk with reward. Although it has limitations, its simplicity and widespread acceptance make it a reliable starting point for investment analysis.
CAPM is a formula that tells you how much return you should expect from a stock based on its risk compared to the market.
Expected Return = Risk-Free Rate + Beta × (Market Return – Risk-Free Rate).
Beta measures how sensitive a stock is to market movements — higher beta means higher risk and potentially higher return.
Plug the values of risk-free rate, beta, and market return into the CAPM formula to estimate the expected return.
Calculate your Net P&L after deducting all the charges like Tax, Brokerage, etc.
Find your required margin.
Calculate the average price you paid for a stock and determine your total cost.
Estimate your investment growth. Calculate potential returns on one-time investments.
Forecast your investment returns. Understand potential growth with regular contributions.
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