What Is the Capital Asset Pricing Model (CAPM)?
The Capital Asset Pricing Model (CAPM) is a foundational framework in modern finance that describes the relationship between systematic risk and expected return for an investment. Developed independently by William Sharpe, John Lintner, and Jan Mossin in the 1960s, CAPM builds on Harry Markowitz's portfolio theory to provide a formula that investors and analysts use to price risky securities and estimate the cost of equity capital.
The core insight of CAPM is that investors should only be compensated for bearing systematic risk — the risk that cannot be diversified away. This risk is measured by beta (β), which quantifies how sensitive an asset's returns are to overall market movements. Our free CAPM calculator lets you compute the expected return for any asset, solve for any variable in the formula, and explore how changes in beta or market conditions affect required returns.
The CAPM Formula Explained
The CAPM formula is expressed as:
E(Ri) = Rf + βi × (E(Rm) - Rf)
E(Ri) = Expected return of the investment
Rf = Risk-free rate of return
βi = Beta of the investment
E(Rm) = Expected return of the market
E(Rm) - Rf = Market risk premium (equity risk premium)
The formula states that the expected return of an asset equals the risk-free rate plus a risk premium. The risk premium is the product of the asset's beta and the market risk premium. A higher beta means more systematic risk and therefore a higher expected return to compensate investors.
How to Use This CAPM Calculator
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Choose a Calculation Mode
Select one of four tabs: Expected Return, Risk-Free Rate, Beta, or Market Return. Each mode solves for a different unknown variable while using the others as inputs.
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Enter Your Parameters
Input the known values. For the risk-free rate, use the current yield on 10-year US Treasury bonds (typically 4-5%). For beta, look up the stock's beta on any financial data provider. For market return, the S&P 500 historical average is around 10%.
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Click Calculate
Press the Calculate button to see your results. The calculator displays the expected return, all input parameters, the market risk premium, and a step-by-step formula breakdown.
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Explore the Sensitivity Analysis
Review the Security Market Line chart and sensitivity tables to see how changes in beta or market return affect the expected return. This helps you understand the risk-return tradeoff for different investment scenarios.
Key Components of CAPM
Risk-Free Rate (Rf)
The risk-free rate represents the return an investor can earn with zero risk. In practice, the yield on US Treasury securities is used as a proxy. The 10-year Treasury yield is most commonly used for equity valuation, while the 3-month T-bill rate is used for shorter-term analysis. As of 2025, the 10-year Treasury yield hovers around 4-5%.
Beta (β)
Beta measures the sensitivity of an asset's returns to market movements. A beta of 1.0 means the asset moves in lockstep with the market. A beta greater than 1.0 indicates higher volatility (e.g., tech stocks often have betas of 1.2-1.5), while a beta less than 1.0 indicates lower volatility (e.g., utilities often have betas of 0.4-0.7). A negative beta means the asset moves inversely to the market.
Market Risk Premium (Rm - Rf)
The market risk premium, also called the equity risk premium (ERP), is the excess return that the overall stock market provides over the risk-free rate. Historically, the US equity risk premium has averaged around 5-7% per year. This premium compensates investors for bearing the uncertainty of equity markets compared to risk-free government bonds.
Security Market Line (SML)
The Security Market Line is the graphical representation of CAPM. It plots expected return on the Y-axis against beta on the X-axis. All correctly priced assets should fall on the SML. Assets above the line are considered undervalued (offering excess return for their risk), while assets below the line are overvalued. The SML intercept is the risk-free rate, and its slope is the market risk premium.
Practical Applications of CAPM
Cost of Equity Estimation
CAPM is widely used in corporate finance to estimate the cost of equity, a key input in the Weighted Average Cost of Capital (WACC) and Discounted Cash Flow (DCF) valuation models.
Portfolio Management
Portfolio managers use CAPM to evaluate whether an asset offers sufficient return for its risk level. By comparing actual returns to CAPM-predicted returns, they can identify alpha — the excess return above what CAPM predicts.
Capital Budgeting
Companies use CAPM-derived discount rates to evaluate new projects and investments. The expected return from CAPM serves as the hurdle rate — projects must exceed this return to create shareholder value.
Security Valuation
Analysts use CAPM to determine whether a stock is fairly priced. If a stock's expected return (based on its current price) is above the SML, it may be undervalued and worth buying.
Limitations of CAPM
While CAPM remains one of the most widely taught and used models in finance, it has well-known limitations. The model assumes that investors can borrow and lend at the risk-free rate, that markets are perfectly efficient, and that all investors have homogeneous expectations. In reality, these assumptions rarely hold.
Empirical research has shown that beta alone does not fully explain differences in stock returns. The Fama-French three-factor model adds size and value factors, while the Carhart four-factor model includes momentum. Despite these limitations, CAPM remains a useful starting point for understanding risk-return relationships and is still the most commonly used model for estimating the cost of equity in corporate finance.