The Capital Asset Pricing Model (CAPM)
A commonly used formula for estimating the required return on an investment is the Capital Asset Pricing Model (CAPM), which is based on the assumption that in an efficient market investors will demand compensation for relative market risk when selecting securities.
The Capital Asset Pricing Model formula is E(r) = r(f) + B[Er(m) - r(f)]
where E(r) is the required return for a security, r(f) is the risk-free rate of return, B is Beta or the multiple of the security’s volatility relative to the overall market’s volatility and the portion in brackets is the market risk premium, or the difference between the expected return on the overall market and the risk free rate.
Historically the stock market has returned an average of about 5% more than the risk free rate, though investors may use other estimates of the market risk premium. If the average historical return is used for a stock that is twice as volatile as the market (a Beta of 2) while the risk-free rate is 4% the CAPM suggests that investors should demand a return of 4%+ 2(5%) = 14%. The term in brackets is compressed to just the market risk premium in this example. The expected return on the market would be the 4% risk-free rate plus the 5% risk premium, or 9%.
For more information, see all articles on: Investing in Stocks, Investment Returns, Portfolio Management, Security Selection, Valuation See also:
The Intelligent Investor: The Classic Text on Value Investing
Financial Statement Analysis: A Practitioner's Guide, 3rd Edition
Managing Investment Portfolios: A Dynamic Process (CFA Institute Investment Series)
