The capital asset pricing model, or CAPM, is a financial model used to estimate the return investors may require for owning a stock or another risky asset. It links expected return to the risk-free rate, the asset’s sensitivity to market movements, and the market risk premium.
What CAPM Represents
CAPM is commonly used as a simplified way to think about the relationship between risk and expected return. In practice, it helps frame why assets with higher market sensitivity may be expected to offer higher returns than assets with lower market sensitivity.
Within valuation work, CAPM is often referenced as one method for estimating the cost of equity, which then feeds into broader concepts such as the capital asset pricing model page in the valuation concepts structure.
Main Components of CAPM
The model is typically expressed through three main inputs: the risk-free rate, beta, and the equity market risk premium. The risk-free rate reflects the return on an asset with minimal default risk, beta measures how sensitive a stock is to broader market movements, and the market risk premium represents the additional return investors expect from equities over the risk-free rate.
How Investors Use the Term
Investors usually encounter CAPM in valuation discussions rather than as a standalone decision tool. It is most often used as a definitional concept that helps explain how required return estimates are built, especially in discounted cash flow and related valuation frameworks.
FAQ
Is CAPM the same as the cost of equity?
No. CAPM is a model that can be used to estimate the cost of equity, but the cost of equity is the output, not the model itself.
What does beta mean in CAPM?
Beta measures how much an asset tends to move relative to the overall market. A higher beta suggests greater sensitivity to market movements.
Is CAPM only used for stocks?
It is most commonly discussed in equity valuation, but the broader logic is about estimating required return for risky assets in relation to market risk.