Flow of the CAPM Formula article
- Capital Asset Pricing Model Formula
- Capital Asset Pricing Model Calculator
- Capital Asset Pricing Model Template
Capital Asset Pricing Model Formula: What is the formula?
If you want to know the rate of return of a risky asset or a stock, you can use capital Asset Pricing Model formula (CAPM) to calculate that.
Here’s the formula for Capital Asset Pricing model –
- Ra = required rate of return of the asset;
- Rrf = the rate of return of a risk free security;
- Rm = the broad market’s expected rate of return;
- Ba = beta of the particular asset.
Explanation of Capital Asset Pricing Model Formula
To understand the formula, we need to look at each component of the formula.
- Required rate of return of the asset or the stock: This is what we intend to find out. If we find any risky asset or stock, by using CAPM formula, we can calculate the required rate of return.
- Rate of return of a risk free security: When you put your money into a fixed deposit, you know that your money is safe and secured. Here we are talking about similar risk free security and its rate of return in normal circumstances.
- Expected rate of return of the broad market: When the investor invests into the broad market, they take a systematic risk inherent within. And as a reward they get a premium. We call it expected rate of return of the broad market.
- Beta of the particular asset or stock: Beta represents the systematic risk of the broad market inherent within the asset.
Use of Capital Asset Pricing Model Formula
We use the capital asset Pricing Model Formula for finding out the required rate of return of a particular asset or a particular stock. Along with that, if you are calculating WACC (Weighted Average Cost of Capital), you may need to use CAPM formula to find out the cost of capital of equity. On a side note, we calculate WACC to find out how much cost a firm needs to incur to borrow money from the shareholders and the creditors.
CAPM quantifies the relationship between risk and required return in a well-functioning market.
Here’s the Cost of Equity CAPM formula for your reference.
Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-free Rate of Return)
Capital Asset Pricing Model Formula Example
Let’s take a simple example to illustrate this.
Ramen wants to know the required rate of return of a stock he wants to invest into. He has gathered all the information –
- Rate of return of a risk-free security – 7%
- Expected rate of return of the broad market – 12%
- Beta of the particular stock – 0.80
By using the Capital Asset Pricing Model Formula, Ramen needs to find out the rate of return of that particular stock.
In this example, we have all the information.
All we need to do is to put the information into the Capital Asset Pricing Model formula.
The CAPM formula is as follows.
- Or, Ra = 0.07 + 0.8 (0.12 – 0.07)
- Or, Ra = 0.07 + 0.8 * 0.05
- Or, Ra = 0.07 + 0.04
- Or, Ra = 0.11 = 11%.
So from the calculation, Ramen finds out that the required rate of return of that particular stock is 11%.
Since CAPM formula helps one find out the fair value of a stock, you can also compare the market value and decide whether the particular investment is right for you or not.
Starbucks CAPM Example
Let us calculate Cost of Equity using CAPM formula.
Cost of Equity CAPM formula Ke = Rf + (Rm – Rf) x Beta
#1 – RISK-FREE RATE
10 year treasury rate can be a good representative of Risk-free rate.
source – bankrate.com
EQUITY RISK PREMIUM (RM – RF)
Starbucks listed in the US has an equity risk premium of 6.25%.
source – stern.nyu.edu
Beta of Starbucks has decreased over the past five years. We note that Beta of Starbucks is at 0.794x
With this, we have all the necessary information to calculate CAPM cost of equity.
- CAPM formula Ke = Rf + (Rm – Rf) x Beta
- Ke = 2.42% + 5.69% x 0.794
- Ke =6.93%
Capital Asset Pricing Model Calculator
You can use the following Capital Asset Pricing Model Calculator
|Ra Formula = Rrf + Ba (Rm - Rrf)|
|0 + 0 (0 - 0) = 0|
Capital Asset Pricing Model in Excel (with excel template)
Let us now do the same example above in Excel. This is very simple. You just need to put the information into the Capital Asset Pricing Model formula.
You can easily find the required rate of return of that particular stock.
You can download this Capital Asset Pricing Model template here – Capital Asset Pricing Model Excel Template
Recommended Articles –
This has been a guide to Capital Asset Pricing Model Formula, practical examples, and Capital Asset Pricing Model calculator along with excel templates. You may also have a look at these articles below to learn more about Valuation Analysis –
- Risk-Adjusted Returns
- Mistakes in DCF
- Enterprise Value Formula
- Dividend Discount Model – Complete Beginner’s Guide
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