What Is the CAPM or Capital Asset Pricing Model?

The CAPM is a model used to determine an investor’s “expected return,” or how much percentage profit that a company investor should logically demand as a “fair” return for investing in a company.

To find this, another question may be asked: How much is the logical “fair” percentage return that an investor should get if he invests in an individual company (with relatively high risk) instead of putting his money in government bonds which are assumed to be “risk free” and instead of putting his money in the general stock market assumed to have “medium” risk?

Obviously, it’s only “fair” that that the investor gets a return of higher than the government bond rate (because the individual company has higher risk). It’s also only fair that he should expect a return higher than the general stock market return, because the individual company has higher risk than the “medium risk” general stock market. So again, how much exactly should this investor fairly earn as a minimum expected return?

This is where the CAPM or Capital Asset Pricing Model comes in. The CAPM Formula puts all these variables together: riskiness of the individual company represented by its “beta,” riskiness of the general stock market, interest rate a “risk free” government bond would give, and others… and then spits out an exact percentage that that the investor “deserves” to get for investing his or her money into this “riskier” individual company.

This exact percentage is now known as the “expected return,” because it is the return that he should “expect” or demand to get if he invests his money into an individual company. This exact percentage is also known as the “cost of equity”.

The CAPM Formula looks something like this:

Expected Return =

Govt. Bond Rate + (Risk represented by “Beta”)(General Stock Market Return – Govt. Bond Rate)

Using this formula, we can find the (theoretically) exact rate of return the individual company investor should fairly expect for his or her investment, if the Capital Asset Pricing Model is to be believed.

Nowadays, it’s no longer necessary to do the calculation yourself because of the availability of many online calculators which can compute the expected return in a flash. It is important, of course, to understand the concept so you can apply it in your business decisions. However, those who need to do calculations but have difficulty using written representations of the formula may simply watch online tutoring videos from various websites or even YouTube.

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