CAPM Calculator - Capital Asset Pricing Model

What Is the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a financial model used to estimate the expected return of an investment based on its level of market risk. It helps investors understand whether the potential return of an investment is appropriate for the amount of risk they are taking.

The basic idea behind CAPM is that investors should expect a higher return when they take on higher systematic risk, which is the type of risk associated with overall market movements and cannot be completely eliminated through diversification.

CAPM Formula

The CAPM formula is used to estimate the expected return of an investment based on its level of market risk. It considers the risk-free rate, the investment's beta, and the expected market return.

Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)

Each part of the formula represents a different factor that helps calculate the CAPM expected return.

1. Risk-Free Rate

The risk-free rate represents the return an investor could expect from an investment with very low or negligible default risk. Government securities are commonly used as a reference for this rate.

For example, if the risk-free rate is 4%, an investor would use 4% as the starting point when calculating the expected return.

2. Beta

Beta measures how sensitive an investment is to movements in the overall market.

• Beta = 1: The investment tends to move in line with the market.
• Beta > 1: The investment tends to be more sensitive to market movements.
• Beta < 1: The investment tends to be less sensitive to market movements.

For example, a beta of 1.2 indicates that the investment has historically been more sensitive to market movements than an investment with a beta of 1.

For investors who want to understand market sensitivity at the portfolio level, a Portfolio Beta Calculator can help estimate how a collection of investments may respond to market movements based on their individual betas and portfolio weights.

3. Market Return

The market return is the expected or assumed return of the overall market over the same period being analyzed.

For example, if the expected market return is 10%, this figure is used in the formula to estimate the investment's expected return.

4. Market Risk Premium

The market risk premium is the additional return expected from the market compared with the risk-free rate.

Market Risk Premium = Market Return − Risk-Free Rate

For example, if the market return is 10% and the risk-free rate is 4%:

Market Risk Premium = 10% − 4% = 6%

This 6% represents the additional return associated with taking market risk compared with the risk-free rate.

How to Use the CAPM Calculator

The CAPM Calculator helps estimate the expected return of an investment using three key inputs: the risk-free rate, market return, and beta. Follow these simple steps to calculate the expected return.

Step 1: Enter the Risk-Free Rate

Enter the Risk-Free Rate (Rf) as a percentage. This is typically based on the yield of a low-risk government security, such as a 10-year Treasury yield.

For example, if the applicable risk-free rate is 4%, enter 4 in the calculator.

Step 2: Enter the Market Return

Enter the Market Return (Rm) as a percentage. This represents the expected return of the overall market, such as the S&P 500.

For example, if you expect the market to return 10%, enter 10.

Step 3: Enter Beta

Enter the investment's Beta (β). Beta measures how sensitive an investment is to movements in the overall market and represents its systematic risk relative to the market.

For example:

• Beta = 1.0: The investment generally moves in line with the market.
• Beta > 1.0: The investment tends to be more sensitive to market movements.
• Beta < 1.0: The investment tends to be less sensitive to market movements.

Step 4: Review the Calculation Breakdown

If you want to see how the result is calculated, select Show Calculation Breakdown. This option can help you understand how the risk-free rate, market return, and beta are used in the CAPM formula.

Step 5: Check the Expected Return

After entering all the required values, click Calculate. The calculator will display the investment's expected return based on the inputs you provided.

CAPM Calculation Example

A simple numerical example can make the CAPM calculation easier to understand and help you check the result shown by a calculator.

Example Inputs

• Risk-free rate: 4%
• Beta: 1.2
• Market return: 10%

Calculation

The CAPM formula is:

Expected Return = Risk-free Rate + Beta × (Market Return − Risk-free Rate)

Using the example values:

Expected Return = 4% + 1.2 × (10% − 4%)

Expected Return = 4% + 1.2 × 6%

Expected Return = 4% + 7.2%

Expected Return = 11.2%

So, the estimated expected return is 11.2%.

This means that, under the assumptions of the CAPM model, an investment with a beta of 1.2 would have an estimated required or expected return of 11.2% based on a 4% risk-free rate and a 10% expected market return.

This example also makes it easier to verify the calculator's result manually and understand how each input affects the final expected return.

CAPM Applications in Investment Analysis

CAPM is useful for estimating the return investors may require for taking on a particular level of market risk. However, expected returns alone do not tell the whole story. Investors can also evaluate how efficiently an investment has performed relative to its risk using a Sharpe Ratio Calculator. The Sharpe ratio considers an investment's excess return over the risk-free rate relative to its volatility, providing a different perspective from CAPM's systematic-risk-based estimate.

Businesses can also use CAPM to estimate their cost of equity, which represents the return shareholders may require for investing in a company. A Cost of Equity Calculator can help with this calculation. The estimated cost of equity can then be used as part of a company's overall financing cost through a WACC Calculator, which combines the costs of equity and debt using their respective weights in the capital structure.

For individual investors, evaluating investment performance may also involve comparing the amount invested with the resulting gain or loss. A ROI Calculator can help measure the return on an investment, while a Stock Average Calculator can help calculate the average purchase price when shares of the same stock are bought at different prices. These tools address different aspects of investing and complement, rather than replace, CAPM analysis.

Frequently Asked Questions (FAQs)