The capital asset pricing model ( CAPM ) is used to determine the required rate of return on a security, it is the cost of equity.  When investing in a security an investor expects a certain return.  This expectation comes from the opportunity cost of putting their money in a certain security as opposed to what it could be earning in a different security.  It also comes from the risk is associated with putting their money in that security.  The CAPM seeks to value that opportunity cost and the risk of the specific security to determine what the required rate of return the investor will have to have to invest their money in this security.  Before we go on, let’s exam the model.

The Capital Asset Pricing Model ( CAPM ) is calculated as follows:

r_a = r_f +β_a( r_m - r_f )

Where:

r_a = required rate of return of the security

r_f = risk-free rate

β_a = beta of the security

r_m = return of the market

Now that we have the formula, let’s pick it apart some more and see why it is put together the way it is as well as find where we can obtain the values for these variables.  The risk-free rate, r_f, is in the equation to signify the opportunity cost of what the money that is invested could be earning.  A United States government bond is usually used to represent the risk-free rate.  A US bond only carries risk if the US government no longer exists, because even if the US government does not have the funds they can print more funds or raise taxes.  There is considered to be a certain premium that needs to be paid for being in the market opposed to a risk-free asset like a US bond.  If there was no greater reward for being in the market, then why would you take the greater risk?  That premium is the return of the market, r_m, subtracted by the risk-free rate, r_f, and is referred to as the equity market premium.  The equity market premium needs to be multiplied by the specific security’s beta, β_a,the statisitcal measure of the security’s volatility in comparison to the market, to see what the premium needs to be for this security.  In other words, the equity market premium multiplied against the security’s beta gives you the amount you need to be compensated in order to assume that amount of risk, a risk premium.  Add that premium to the opportunity you are giving up to invest in, the risk-free rate, and you have your required rate of return on that specific security, r_a.

The capital asset pricing model ( CAPM ), however, is not perfect.  Beta is measuring past prices, and the past is not always an indication of the future.  Beta also does not ecompass all of the valuable information of a security.  There are also different ways to calculate a security’s beta, which can lead to varying required rate of returns of a security .  Smaller capitalization stocks also tended to outperform CAPM evaluations, most likely because they are not accuratley captured in the return of the market, r_m.  However, even for its shortcomings CAPM is very useful to calculate the cost of equity and is widely accepted.  Its creators even received a Nobel Prize for it in the sixties, no alternate method has had any such recognition or acceptance.  But, there is an alternative method for calculating the cost of equity, the dividend capitalization model.  CAPM and the dividend capitalization model are both used for Discounted Cash Flow analysis (DCF).