A Capital Asset Pricing Model (CAPM) Calculator
The Capital Asset Pricing Model (CAPM) is used to estimate the rate of return an investor should expect to receive given the risk profile of a stock (or another asset). In calculating the expected return on the stock, the CAPM factors in this risk along with the time value of money to arrive at the estimate. For valuation purposes, the model is used to determine a discount rate to assign a present value to a stock.
The CAPM Formula
Even a diverse portfolio assumes some level of risk. Rational investors expect a rate of return that compensates for that risk. The CAPM helps us the investor to clarify their investment risk and the return on investment they should expect given that risk. The basic formula for the CAPM can be written as:
Expected Return = Risk Free Rate + Risk Premium
Within this formula, the time value of money is represented by the risk-free rate; the compensation to the investor for investing over a period of time. The other piece of the formula incorporates the level of risk the investor has taken on and calculates appropriate compensation.
Some Guidelines in Using the Calculator:
- The risk-free interest rate is the rate the investor would expect to receive from a risk-free investment, such as U.S. Treasury Bills.
- Stock beta is used to demonstrate the relationship between the movements of an individual stock versus the market as a whole. To find the stock’s beta, got to Yahoo! Finance and enter the stock symbol in the Get Quotes window. ON the left-hand side, under Company, click on Key Statistics. The beta appears on the right-hand side under Stock Price History.
- The expected market return is the return the investor would expect from a broad stock market index, such as the S&P 500.
Stock Beta and the CAPM
Beta is a measure of a stock’s volatility in relation to the market. The market as a whole, by definition, has a beta of 1.0. Individual stocks are assigned beta values according to how much they deviate from the market. Stocks that have proven to swing more than the market would have a beta greater than 1.0. Stocks that demonstrate less of a swing in relation to the market have a beta of less than 1.0. Stocks with higher beta scores are seen as riskier and should provide the potential for higher returns to the investor. Beta is a key component for the CAPM calculation.
Potential Flaws in the Model
For the CAPM to work, stock prices must be arrived at in markets that are completely efficient is dispersing information to investors. The model also relies on historical information, which might not accurately foretell the future.
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The above information is educational and should not be interpreted as financial advice. For advice that is specific to your circumstances, you should consult a financial or tax advisor.
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