CAPM (Capital Asset Pricing Model)
Executive Summary
Key Takeaways
- ✓ CAPM estimates cost of equity as: risk-free rate + beta × equity risk premium.
- ✓ Beta measures a stock's systematic risk relative to the overall market; a beta above 1.0 indicates higher-than-market volatility.
- ✓ The equity risk premium is the additional return investors require above the risk-free rate to hold equities as an asset class, and is not directly observable.
- ✓ For private companies or specific projects, beta is typically estimated from comparable listed companies, unlevered and then relevered at the subject's target capital structure.
- ✓ CAPM is a single-factor model; multi-factor extensions exist but CAPM remains the dominant convention in institutional valuation practice.
Definition¶
The Capital Asset Pricing Model (CAPM) is the standard methodology for estimating cost of equity — the return equity investors require to hold a company's stock, given its systematic (market-related) risk.
Formula¶
Cost of Equity (Re) = Rf + β × (Rm - Rf)
Where:
Rf = Risk-free rate
β (beta) = Systematic risk of the equity relative to the market
Rm = Expected market return
(Rm - Rf) = Equity risk premium (ERP)
The Three Inputs¶
Risk-free rate (Rf). Typically the yield on long-term government bonds in the relevant currency, with tenor matched to the investment horizon. Using a mismatched tenor (for example, a short-term bill rate for a long-horizon valuation) understates the true risk-free rate.
Beta (β). Measures how much a stock's returns move relative to the overall market. A beta of 1.0 moves in line with the market. Beta above 1.0 indicates higher systematic risk than the market average; below 1.0 indicates lower systematic risk. For private companies or specific projects with no directly observable beta, practitioners:
- Identify a set of comparable listed companies
- Un-lever each comparable's observed beta to remove the effect of its own capital structure
- Average the resulting unlevered (asset) betas
- Re-lever the average at the subject company's or project's target capital structure (using the Hamada equation or an equivalent formula)
Equity risk premium (ERP). The additional return investors require, above the risk-free rate, to hold equities as an asset class rather than a risk-free instrument. ERP is not directly observable and is typically estimated from long-run historical equity return data, implied ERP models, or practitioner surveys — different sources can produce materially different estimates.
Role in a DCF Valuation¶
CAPM produces the cost of equity, which is one of the two components of WACC (the other being the after-tax cost of debt). In an FCFE-based valuation, the CAPM-derived cost of equity is used directly as the discount rate rather than being blended into WACC.
Audit Considerations¶
- Verify the source and date of the risk-free rate, and confirm its tenor is matched to the valuation horizon
- Verify the beta source: which comparable companies were used, whether unlevering and relevering were performed correctly, and whether the target capital structure used for relevering matches the capital structure assumed elsewhere in the model
- Verify the equity risk premium source and confirm it is disclosed, since ERP is a judgement input with a wide range of defensible values
- Confirm any country or size premium additions are separately disclosed and justified, not silently embedded in the beta or ERP figure
Common Errors¶
| Error | Description | Risk |
|---|---|---|
| Undisclosed ERP source | ERP figure used without stating its source or date | Cost of equity cannot be independently assessed or replicated |
| Incorrect beta relevering | Comparable betas not correctly unlevered and relevered | Cost of equity misstated, propagating into WACC and the whole valuation |
| Mismatched risk-free rate tenor | Short-term rate used for a long-horizon valuation | Understates the risk-free rate and therefore cost of equity |
Continue Reading¶
Prerequisites¶
- Discounted Cash Flow (DCF) Valuation — the parent pillar
Related Glossary¶
How OXXON tests thisRun a free structural check with FMAE
Frequently Asked Questions
What is the CAPM formula?
Cost of equity = Risk-free rate + Beta × Equity Risk Premium, where Equity Risk Premium is the expected market return minus the risk-free rate.
What is beta in CAPM?
Beta measures the sensitivity of a stock's returns to overall market returns. A beta of 1.0 moves in line with the market; a beta above 1.0 indicates greater systematic risk (more volatile than the market); a beta below 1.0 indicates lower systematic risk.
How is beta estimated for a private company?
By observing the betas of comparable listed companies, unlevering each to remove the effect of its own capital structure, averaging the unlevered betas, and then relevering the result at the subject company's or project's target capital structure using the Hamada equation or an equivalent formula.
Where does the equity risk premium come from?
The equity risk premium is not directly observable and is estimated using historical average equity returns over the risk-free rate, dividend discount model-implied premia, or surveys of practitioner expectations. Different sources can produce materially different ERP estimates, so the source and date should always be disclosed.
Is CAPM the only way to estimate cost of equity?
No. Multi-factor models (such as the Fama-French three-factor model) and build-up methods exist, but CAPM remains the dominant single-factor convention used in institutional DCF practice due to its simplicity and wide acceptance.
Related Articles
Cost of Equity
Cost of equity is the rate of return equity investors require to compensate them for the risk of holding a company's stock, given its systematic risk relative to the broader market. It is most commonly estimated using the Capital Asset Pricing Model (CAPM), which expresses cost of equity as the risk-free rate plus a beta-adjusted equity risk premium. Cost of equity serves two roles in a DCF valuation: it is one of the two components blended into WACC (alongside the after-tax cost of debt), and it is used as the sole discount rate when valuing a levered cash flow (FCFE) directly.
WACC (Weighted Average Cost of Capital)
WACC (Weighted Average Cost of Capital) is the rate of return that a company must earn on its existing assets to maintain the value of its equity and satisfy both its debt holders and equity investors. It is calculated as the weighted average of the after-tax cost of debt and the cost of equity, with the weights determined by the proportion of each in the total capital structure. WACC is used primarily as the discount rate in a discounted cash flow (DCF) valuation, where it converts projected free cash flows into present value. It is also used as a return hurdle: a project or investment is value-creating if its expected return exceeds the WACC.
Discounted Cash Flow (DCF) Valuation
Discounted cash flow (DCF) valuation values a business, project, or asset as the present value of the cash flows it is expected to generate in the future. It is the most theoretically grounded of the major valuation methodologies, resting directly on the principle that a dollar of cash flow is worth more today than the same dollar received in the future, and that value is created when future cash flows exceed what capital providers require as compensation for the time value of money and risk. This page is the hub for the Knowledge Centre's DCF content: what DCF is and why it works, how free cash flow and discount rates are built, how terminal value is calculated and stress-tested, the method variants practitioners choose between, and — distinctively — how DCF failure modes map onto FMAE's existing structural audit rule taxonomy, since no generic valuation resource ties DCF mechanics to a named, testable audit standard.