CAPM Formula Example: How to Calculate CAPM for Securities

“CAPM” is an acronym financial analysts use to refer to the Capital Asset Pricing Model. This model allows investors to follow one of the most important precepts of modern portfolio theory: By knowing the risk-free rate of a security, you can extrapolate how well the stock return will increase in relation to risk. The same is true when it comes to evaluating other assets like government bonds and US treasury bills.

CAPM works by weighing the cost of capital against systematic risk, as well as the possibility of return. It does so by utilizing risk-free rates, market risk premiums, volatility or beta variables, and so on to calculate the expected return on an asset overall.

CAPM helps investors get an idea of how each asset in their portfolio might perform in both the long and short terms. Investors are more likely to take on assets with a higher risk of loss if they can also assure themselves they carry the possibility of a higher return as well.

This allows investors to build out portfolios with diversifiable risk. CAPM might indicate some stocks will likely overperform the market, others might stay the course with the overall market, and still others might underperform the market. By taking all this into consideration, investors can hedge against high-risk (and potentially high-reward assets) with more stable and reliable investments.

To calculate the expected return on assets, you must utilize the CAPM formula: Expected return = risk-free rate + volatility/beta * (market return - risk-free rate). For further help in utilizing this formula, keep these steps in mind:

1. 1. Assess the risk-free rate of your asset. Start by figuring out a given stock’s risk-free rate of return. This is the amount of interest you would expect to gain on your asset in a hypothetical world with no risk whatsoever. You’ll now utilize this variable in two separate places.
2. 2. Find the difference in your market risk premium. To find your market risk premium, determine which overall market return metric you’d like to use. You could use the S&P 500, Dow Jones Industrial Average, or another relevant market’s total percentage of growth. Subtract your risk-free rate percentage from this market return variable. The difference is your market risk premium.
3. 3. Multiply the market risk premium by volatility. Find the product of your market risk premium and the stock’s beta (or volatility). This measure of risk indicates how much risk the stock would expose you and your portfolio to in the real world. This is where CAPM moves from the realm of the theoretical into a more pragmatic direction.
4. 4. Resolve the problem. You’ll conclude your calculations by adding the risk-free rate to the product of your market risk premium and volatility. This will yield you the required rate of return (or discount rate) of the stock in question. You can then decide whether or not you want to take on the specific risks of purchasing the asset in question.

The CAPM formula comes with some built-in benefits for investors and financial professionals. Here are just a few to consider:

• Investment encouragement: CAPM helps you get a better idea of the weighted average cost of capital (WACC) in general as well as the time value of money in your own portfolio, not to mention other key financial factors. As such, it helps risk-averse investors rest easier about taking on assets with a little more assurance that the reward of the stock itself, as well as portfolio diversification, will outweigh any potential losses.
• Portfolio diversification: Different asset classes—and different individual assets, for that matter—come with different levels of innate risk. When you use the CAPM formula, investors get a potentially accurate idea of the expected returns on all their individual stocks. This can help them diversify their portfolios as a result.
• Risk management: Calculating any additional risk with help from the CAPM formula allows you to see if your portfolio will hew closely to the capital market line (CML) and security market line (SML). Both these metrics indicate a given asset is performing at the same rate as or even better than the market as a whole.

The CAPM model does come with some unfortunate drawbacks. Consider these potential cons:

• Assumption of constancy: CAPM assumes the present value of stock prices and other variables will remain constant enough to project future financial behavior. History has taught investors again and again that constancy is very difficult to count on in financial markets, whether in terms of stock performance, interest rates, or just about anything else. A lot of things can change. This can expose you to greater risk and loss than you anticipated.
• Fluctuating variables: The present and past performance of assets and the market as a whole can only tell you so much—every percentage is likely to change. CAPM assumes the opposite, that the variables you use in the formula are not prone to fluctuations and can thus help predict future cash flows and asset performance. Relying too heavily on CAPM can prove risky as a result.
• Lack of information: This form of financial modeling leaves plenty of variables out of the equation. There are plenty of other factors happening within the overall stock market that can affect the performance of an asset that CAPM ignores. The same goes for many forms of unsystematic risk.

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