Capital Asset Pricing Model (CAPM)

Quick Definition

The Capital Asset Pricing Model (CAPM) is a formula that calculates the expected return an investor should require for holding a risky asset, based on how much risk that asset adds to a diversified portfolio. The model uses three inputs: the risk-free rate, the asset's beta (its sensitivity to market movements), and the equity risk premium (the extra return investors demand for holding stocks instead of risk-free assets).

What It Means

CAPM answers a fundamental question in investing: how much return should I expect for the risk I am taking? If you buy a Treasury bond, your return is known and guaranteed by the US government, so the risk is near zero. If you buy a stock, your return is uncertain, so you demand a premium over the risk-free rate to compensate for that uncertainty. CAPM quantifies that premium.

The model was developed in the 1960s by William Sharpe, John Lintner, and Jan Mossin, building on Harry Markowitz's modern portfolio theory. Sharpe received the Nobel Prize in Economics in 1990 for this work. Despite being more than 60 years old, CAPM remains the most widely used method for estimating the cost of equity in corporate finance and valuation.

CAPM is used in three main ways:

1. Corporate finance: Companies use CAPM to estimate their cost of equity, which feeds into the Weighted Average Cost of Capital (WACC) used to evaluate projects and acquisitions
2. Stock valuation: Analysts use CAPM to determine the discount rate for discounted cash flow models
3. Portfolio management: Investors use CAPM to assess whether a stock's expected return justifies its risk

The model's key insight is that investors are only compensated for systematic risk (market risk that cannot be diversified away), not for unsystematic risk (company-specific risk that diversification eliminates). A stock with a beta of 1.5 should return 50 percent more than the market premium above the risk-free rate, because it carries 50 percent more market risk. A stock with a beta of 0.5 should return only half the market premium.

How It Works

The CAPM Formula

Expected Return = Rf + Beta x (Rm - Rf)

Where:

• Rf = Risk-free rate (typically the 10-year Treasury yield)
• Beta = Sensitivity of the stock's returns to market returns
• Rm = Expected return of the market
• (Rm - Rf) = Equity risk premium

The Three Inputs

1. Risk-Free Rate

The risk-free rate is the return on an investment with zero default risk. In practice, the yield on US Treasury securities is used. For long-term equity valuation, the 10-year Treasury yield is the standard choice because it matches the long-term horizon of equity investments.

As of August 2026, the 10-year Treasury yield was approximately 4.69 percent, according to the US Treasury daily yield curve data. The federal funds rate was 3.63 percent, and the 3-month Treasury bill yielded about 3.69 percent. For CAPM purposes, the 10-year yield is preferred because equities are long-duration assets.

2. Beta

Beta measures how much a stock's returns move with the overall market. A beta of 1.0 means the stock moves in lockstep with the market. A beta of 1.5 means the stock moves 50 percent more than the market (if the market rises 10 percent, the stock rises 15 percent). A beta of 0.5 means the stock moves half as much as the market.

Beta is calculated using regression analysis of the stock's historical returns against market returns, typically over the past 3 to 5 years. Some providers (like Bloomberg) adjust beta toward 1.0 to account for the tendency of beta to revert to the mean over time.

3. Equity Risk Premium

The equity risk premium is the extra return investors demand for holding stocks instead of risk-free Treasury bonds. There are two main approaches to estimating it:

• Historical premium: The average excess return of stocks over bonds over a long period. Depending on the time period and methodology used, this produces estimates of 5.5 to 14.5 percent, according to NYU professor Aswath Damodaran's 2026 research.
• Implied premium: The premium implied by current stock prices and expected future cash flows. Damodaran's implied equity risk premium at the start of 2026 was 4.23 percent, which was in line with the historical average over the past 65 years despite elevated stock valuations.

Most practitioners use a forward-looking or implied premium rather than a purely historical one, because historical premiums can be distorted by survivorship bias and specific market conditions. A common range used in practice is 4 to 6 percent.

Calculating Expected Return

Using August 2026 inputs:

• Risk-free rate (10-year Treasury): 4.69 percent
• Equity risk premium: 4.23 percent (implied, Damodaran)

A stock with a beta of 1.3 should return about 10.2 percent, while a stock with a beta of 0.5 should return about 6.8 percent. The difference reflects the additional market risk the higher-beta stock carries.

Real-World Examples

Example 1: Using CAPM in a DCF Valuation

An analyst is valuing a technology company and needs to determine the cost of equity for the discount rate. The company has a beta of 1.25.

• Risk-free rate: 4.69 percent
• Equity risk premium: 5.0 percent (using a slightly more conservative estimate than the implied 4.23 percent)
• Cost of equity = 4.69% + 1.25 x 5.0% = 10.94%

If the company also has debt, the WACC would blend this cost of equity with the after-tax cost of debt. For a company with 80 percent equity and 20 percent debt at a 5 percent pre-tax cost (3.75 percent after-tax at a 25 percent rate):

WACC = 0.80 x 10.94% + 0.20 x 3.75% = 8.75% + 0.75% = 9.50%

This 9.50 percent WACC becomes the discount rate in the DCF model. Read our guide on how the stock market actually works for more on how discount rates affect valuations.

Example 2: Comparing Expected Returns

An investor is choosing between two stocks:

Stock A has returned close to its CAPM expected return, suggesting it is fairly priced. Stock B has returned significantly more than CAPM predicts, which could mean it has generated alpha (outperformance) or that it carries risks not captured by beta. An investor using CAPM would note that Stock B's excess return may not be sustainable and could reflect luck or unmodeled risk factors.

Example 3: Portfolio Beta

An investor holds a portfolio with the following positions:

The portfolio beta is 0.73, meaning it is less volatile than the market. Using CAPM with August 2026 inputs:

Expected portfolio return = 4.69% + 0.73 x 4.23% = 7.78 percent

This portfolio is expected to return about 7.8 percent, which is below the market's expected return of about 8.9 percent but with significantly less risk. The 25 percent cash allocation pulls both the beta and expected return down.

Key Points to Remember

• CAPM calculates expected return as the risk-free rate plus beta times the equity risk premium. It tells you what return you should demand for a given level of market risk.
• As of August 2026, the 10-year Treasury yield was about 4.69 percent and the implied equity risk premium was about 4.23 percent (per Damodaran).
• Beta measures a stock's sensitivity to market movements. A beta of 1.0 matches the market, 1.5 is 50 percent more volatile, and 0.5 is half as volatile.
• Only systematic (market) risk is compensated in CAPM. Unsystematic (company-specific) risk can be eliminated through diversification and earns no premium.
• CAPM is the most widely used method for estimating the cost of equity in corporate finance and DCF valuation.
• The model has known limitations: it assumes investors hold diversified portfolios, markets are efficient, and beta captures all relevant risk. In practice, other factors like size, value, and momentum also explain returns.

Common Mistakes to Avoid

• Using a historical equity risk premium without context: Historical premiums range from 5.5 to 14.5 percent depending on the period. Using a very high historical premium because of a specific bull market period inflates expected returns. Consider using a forward-looking implied premium, which was 4.23 percent at the start of 2026.
• Using the wrong risk-free rate: Match the risk-free rate to the investment horizon. For long-term equity valuation, use the 10-year Treasury yield (about 4.69 percent in August 2026), not the federal funds rate (3.63 percent) or the 3-month T-bill yield (about 3.69 percent).
• Treating beta as stable: Beta changes over time. A stock's beta calculated over the past year may differ significantly from its beta over the past five years. Use a longer measurement period and consider adjusted beta (which reverts toward 1.0).
• Assuming CAPM captures all risk: CAPM only accounts for market risk. Other factors like company size, valuation ratios, profitability, and momentum also explain stock returns. Fama and French expanded CAPM into a three-factor and five-factor model to address these limitations.
• Forgetting that CAPM produces expected, not guaranteed, returns: The model tells you what return you should require, not what return you will get. Actual returns can deviate significantly from CAPM predictions, especially over short periods.
• Applying CAPM to private companies without adjustment: Private companies often have higher risk than their public peers due to lack of liquidity, concentration risk, and smaller size. Apply a size premium and liquidity discount when using CAPM for private company valuation.

Related Concepts

CAPM is closely tied to beta, which measures a stock's market risk. It feeds into the discount rate used in discounted cash flow analysis and broader valuation work. Alpha measures returns above or below what CAPM predicts. The model assumes investors hold diversified portfolios, which eliminates unsystematic risk. Correlation between assets is what makes diversification work. CAPM is a core tool of fundamental analysis and helps investors assess risk versus expected return. Read our guides on how the stock market actually works, common investing mistakes, bull vs bear markets, and the S&P 500 index fund explained. Use our investment return calculator to model your portfolio.

Frequently Asked Questions

Q: What is a good equity risk premium to use in 2026? A: Damodaran's implied equity risk premium at the start of 2026 was 4.23 percent. Historical premiums range from 5.5 to 14.5 percent depending on the period. Most practitioners use 4 to 6 percent. Using the implied premium is generally preferred because it reflects current market conditions rather than historical averages that may be distorted by survivorship bias.

Q: How is beta calculated? A: Beta is calculated by running a regression of the stock's monthly returns against the market's monthly returns (typically the S&P 500) over a period of 3 to 5 years. The slope of the regression line is the beta. Many financial data providers publish pre-calculated betas, often adjusted toward 1.0 to account for mean reversion.

Q: Does CAPM work for individual investors? A: CAPM is most useful as a framework for thinking about risk and return, not as a precise prediction tool. Individual investors can use it to understand why high-beta stocks should deliver higher returns and to set expectations for their portfolio. However, the model's assumptions (efficient markets, diversified investors, beta as the only risk factor) are simplifications of reality.

Q: What are the limitations of CAPM? A: CAPM assumes all investors hold the market portfolio, markets are efficient, and beta is the only measure of risk. In practice, other factors like company size, book-to-market ratio, and momentum also explain returns (the Fama-French model). CAPM also uses historical beta, which may not predict future risk. Despite these limitations, it remains the standard for estimating the cost of equity because it is simple and widely understood.

Q: Where can I find current Treasury yields for the risk-free rate? A: The US Treasury publishes daily yield curve data on its website. As of August 20, 2026, the 10-year Treasury yield was 4.69 percent. The Federal Reserve also publishes interest rate data in its H.15 Selected Interest Rates release.