What is Capital Asset Pricing Model (CAPM)?

Explanation of Capital Asset Pricing Model

The Capital Asset Pricing Model was developed in the 1960s as a framework for linking risk and expected return. It focuses on systematic risk, which reflects exposure to overall market movements and cannot be eliminated through diversification.

The model expresses the expected return on an asset as the sum of the risk-free rate and a risk premium. The risk premium is calculated by multiplying the asset’s Beta by the market risk premium, being the expected excess return of the market over the risk-free rate.

In UK corporate finance and financial reporting contexts, CAPM is widely used to estimate the cost of equity when calculating the weighted average cost of capital. It is applied in discounted cash flow valuations, impairment testing and option pricing exercises, where an objective and transparent estimate of required return is required.

Key characteristics of Capital Asset Pricing Model

Key characteristics of CAPM include:

• It links expected return to systematic risk measured by Beta.
• It distinguishes between risk-free return and market-related risk premium.
• It assumes investors are compensated only for non-diversifiable risk.
• It is widely used in valuation, transaction advisory and financial modelling.
• It provides a structured framework for estimating the cost of equity.

How Capital Asset Pricing Model works

1. A risk-free rate is identified, often based on government bond yields.
2. The market risk premium is estimated as the expected excess return of the market over the risk-free rate.
3. The asset’s Beta is determined, typically through regression analysis or reference to comparable companies.
4. The expected return is calculated by combining these components in the CAPM formula.

Example of Capital Asset Pricing Model in practice

A UK professional services firm is valuing a privately owned business using a discounted cash flow model. To determine the cost of equity, it applies CAPM, using a UK government bond yield as the risk-free rate, an estimated market risk premium and a Beta derived from comparable listed companies. The resulting rate forms part of the weighted average cost of capital used in the valuation.

Related terms

• Beta
• Cost of equity
• Market risk premium
• Risk-free rate
• Weighted average cost of capital (WACC)
• Discounted cash flow (DCF)
• Systematic risk

Frequently asked questions CAPM formula 

What is the CAPM formula?

The CAPM formula states that expected return equals the risk-free rate plus Beta multiplied by the market risk premium. It provides a structured method for estimating the required return on equity.

Why is CAPM used in business valuations?

CAPM is used to estimate the cost of equity, which is a key input in calculating the weighted average cost of capital. This discount rate is then applied in discounted cash flow valuations and other financial modelling exercises.

Does CAPM measure total risk?

No. CAPM focuses on systematic risk, which reflects exposure to overall market movements. It does not directly account for company-specific risks that can be diversified.

Is CAPM applicable to private companies?

Private companies do not have directly observable market Betas. In practice, Beta is often estimated using comparable listed companies and adjusted to reflect the private company’s capital structure for modelling purposes.