What it means
The model rests on one idea: investors should only be paid extra for risk they cannot diversify away. Risk specific to a single company can be spread across a portfolio and therefore earns nothing extra, while risk shared by the whole market cannot be escaped and must be compensated.
Beta is the number that measures how much of that unavoidable market risk an asset carries. A beta of 1 means the asset tends to move in line with the market.
A beta of 1.5 means it tends to move half again as much in both directions, while a beta of 0.6 means it moves less than the market does. Multiplying beta by the market risk premium gives the extra return investors should demand for holding it.
It matters in ordinary business decisions because CAPM is usually how the cost of equity in a discount rate is produced. Change the beta and you change the hurdle every project has to clear, which is why the input deserves scrutiny rather than quiet acceptance.
In practice all three inputs are estimated rather than observed. The risk free rate is normally taken from long dated government bonds, the market risk premium from long run historical averages or survey evidence, and beta from a regression of the share's returns against a market index.
A private company has no share price, so analysts borrow the average beta of listed peers and adjust it for differences in borrowing. The important nuance is that CAPM is a single factor model and markets are messier than that.
Researchers have long found that small companies and cheaply valued shares earn more than their betas alone would suggest, which is why multi factor models were built on top of it. CAPM survives because it is transparent and easy to explain, not because it is precise.
In practice
Real-world examples.
Example
A software company is setting the discount rate for a new product line. It takes a beta of 1.4 from a basket of listed software peers, applies a 5% market risk premium and a 4% risk free rate, and arrives at a 11% cost of equity that becomes the floor for approving the investment.
Example
A pension trustee board compares two asset managers pitching equity funds. Using CAPM, the board works out that the fund with a beta of 1.25 should be expected to return more simply because it carries more market risk, so the higher headline return it reported is not evidence of skill.
Example
A manufacturer is choosing between acquiring a utility business and a consumer electronics business. The utility's low beta of 0.5 gives a cost of equity of 6.5%, while the electronics target's beta of 1.6 gives 12%, so the electronics deal must clear a far higher return to be worth doing.
Formula
Calculation
Expected Return = Risk Free Rate + Beta x (Expected Market Return - Risk Free Rate)
Suppose a company is valuing a division and chooses, for this illustration, a risk free rate of 4%, an expected market return of 9%, and a beta of 1.3 taken from the average of listed peers. These are assumptions picked for the example, not current market figures.
Market risk premium: 9% - 4% = 5%.
Beta adjusted premium: 1.3 x 5% = 6.5%.
Cost of equity: 4% + 6.5% = 10.5%.
So the owners of that division should expect roughly 10.5% a year for the risk they are taking. If the division's plan forecasts a return of 9%, it destroys value even though it is profitable, because 9% is less than investors could expect elsewhere for the same risk.
Note how sensitive this is. With a beta of 0.8 instead, the answer becomes 4% + (0.8 x 5%) = 8%, and the same 9% plan now looks attractive. One estimated input flips the decision, which is why sensible teams run a range of betas rather than a single point.Case study
Seen in the real world.
Meridian Tools is a fictional manufacturer used here only to illustrate the point. Its investment committee had applied a single company wide cost of equity of 9% to every project for years, from replacing machinery to launching a consumer brand.
A new finance director rebuilt the numbers with CAPM, estimating a beta of 0.7 for the core industrial business and 1.5 for the proposed consumer venture. Using a 4% risk free rate and a 5% premium, the industrial hurdle fell to 7.5% while the consumer hurdle rose to 11.5%. Two factory upgrades that had been rejected at 9% were now clearly worth doing, and the consumer venture, forecast at 10%, no longer cleared its own bar.
The illustrative lesson is that one blended hurdle rate quietly subsidises risky projects and penalises safe ones. CAPM's real value at Meridian was not precision, it was forcing the committee to price each decision for the risk it actually carried.
Watch out
Common mistakes.
- Using one company wide cost of equity for every project, so high risk ventures are judged too leniently and low risk ones too harshly.
- Reading beta as a measure of total risk, when it only captures sensitivity to the market and says nothing about company specific risk.
- Taking a beta straight from a data provider without checking the period and index behind it, which can produce very different numbers for the same company.
Questions
People also ask.
Does CAPM give the return an asset will actually earn?
No, it gives the return investors should require for the risk taken, which is a benchmark for judging an investment rather than a forecast.
What should be used as the risk free rate?
Normally the yield on a long dated government bond in the same currency as the cash flows, matched roughly to the life of the investment being valued.
Can CAPM be used for a private company?
Yes, by taking the average beta of comparable listed companies and adjusting it for the private company's level of debt, though the result is an estimate with a wide margin of error.
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