Understand an Calculate the Capital Asset Pricing Model (CAPM)

By Stock Research Pro • May 14th, 2011

Investors calculate the capital asset pricing model (CAPM) to analyze the relationship between risk and return when pricing securities. CAPM provides a valuable data point to the investor based on the idea that a certain level of compensation is to be expected given an element of risk. In calculating CAPM, the formula incorporates the time value of money along with the level of risk to arrive at a discount rate for factoring into stock valuation.

How to Calculate CAPM

Simply put, the formula for CAPM can be described as:

Expected Return = Risk Free Rate + Risk Premium

Where the risk-free rate of return accounts for the time value of money and the other component, the risk premium, builds in the level of risk the investor is willing to take on in this investment. The idea behind building in a risk premium is that, even with a well-diversified portfolio, an investor assumes a certain level of risk and rational investors expect to be compensated in a way that is commensurate to that risk level. In other words, unless rational investors believe they are being fairly compensated given the investment risk, they will forego the investment.

Factoring Stock Beta into the CAPM Calculation

Stock beta is the measure of how volatile a stock is compared to the overall market. When determining beta, the beta of the market as a whole is set to 1.0 and individual stock beta will vary according to their deviation from the movements of the market. Any stock that proves to be more volatile than the market is assigned a beta that is greater than 1.0 and those stocks are assumed to be more risky. Stocks that demonstrate less of a swing than the overall market would carry a beta that is less than 1.0. Those stocks are generally seen as less risky.

Guidelines for Using the CAPM Calculator

  • The rate available from U.S. treasury bills is often used as the baseline for an available risk-free rate of return
  • To find a stock‚Äôs beta, got to Yahoo! Finance, enter the stock symbol in the Get Quotes window and click on the Key Statistics on the left-hand side. You will find the stock beta on the right under the Stock Price History
  • The expected return from a broad market index, like the S&P 500 often serves as the expected market return for the CAPM calculation
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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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