The capital asset pricing model, or CAPM, is used to calculate the theoretically appropriate rate of return on an asset such as a company’s common stock. Our CAPM calculator requires three inputs to determine this value:
- A measure of the market return; the historical return of the S&P 500 is oftentimes used as a proxy for this value
- The risk-free rate of return; United States Treasury yields are a good approximation for this rate
- The beta value for the asset being modeled. In this case, it would be the beta value for an individual security
The calculator then provides the user with one value:
- The risk-adjusted return on a capital asset
Capital Asset Pricing Model Theory
CAPM is used to describe the relationship between the expected return on a security and its risk. The model can be interpreted in this manner:
An investor’s expected return on a security, more often the common stock of a company, is equal to a risk-free return plus the risk premium associated with the security.
Investors will demand higher returns as the risk of an investment increases. The CAPM model attempts to quantify the appropriate return.
The CAPM Formula
The following CAPM formula can be used to calculate the expected rate of return on an investment:
Expected Rate of Return = rf + B x (rm – rf)
- rf = The expected rate of return on a risk-free investment
- B = The beta value of the security
- rm = The expected rate of return for the overall stock market
Risk-Free Rates, Beta Values, and Market Returns
In practice, a risk-free rate of return can be modeled using bonds issued by a governing body since the risk of default is extremely small. It’s also considered good practice to line up the intended investment timeframe with that of the risk-free investment. For example, if the investor’s timeframe to hold a security is one year, then they would use the one-year yield curve rate. Bond yields of various durations can be found on this page.
Beta is a measure of a stock’s price movements relative to the movement of the overall market. Stocks with beta values greater than 1.0 will experience more volatile price swings when compared to overall market movements, while stocks with beta values less than 1.0 will experience smaller price swings than the overall market. Beta values for securities such as common stock can be found on sites such as Yahoo Finance.
Finally, the S&P 500 is typically used as a measure of the overall stock market return. Over a 50-year timeframe, the S&P 500 has provided investors with an average return of 10.8%, which is similar to the 10.2% return over the last 30 years. The consistency of these returns over relatively long timeframes demonstrates the usefulness of this value for this type of calculation.