What is the CAPM formula? The capital asset pricing model (CAPM) formula is a model that calculates the expected rate of return on an investment. Using the formula you can calculate your expected return: Expected return = Rf + (β * MRP).
Knowing how to make the right investments is key to growing a business. It can help expand product offerings, penetrate new markets, and attract investors who are willing to play the long game.
The CAPM formula can help you figure out how much money you expect to make on your investment. This will help you decide if you should take the risk or not. Learn more about what makes up the CAPM formula and how to best leverage it for your business decisions.
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The capital asset pricing model (CAPM) formula calculates an investment’s expected return using three main components: risk-free rate, beta, and market risk premium, resulting in the expected return.
The CAPM formula is:
Expected return = Rf + (β * MRP)
In this equation, Rf is the risk-free rate, β is beta, and MRP is the market risk premium. To use the CAPM formula:
Your returned value, or expected return, will be the estimated annual return on investment or asset. While there are no set “rules,” a double-digit result is considered good, and most land between 10% and 15%.
A single-digit result might be acceptable for lower-risk investments but should be heavily inspected against other valuation methods to ensure you’ve made a suitable investment.
CAPM is a theoretical number, not an exact guarantee. Your actual return on investment or asset might differ.
Let’s assume the following information:
Using our formula for CAPM:
Expected Return = Rf + (β * MRP)
Expected Return = 2.5 + (1.1 * 6)
Expected Return = 2.5 + 6.6
Expected Return = 9.1%
This means that your investment or asset will see a return of 9.1% annually.
Since these base numbers change over time, regularly reviewing and recalculating these figures is essential for the most accurate information.
The CAPM model is one of many accounting formulas that has various use cases:
CAPM isn’t the only model you can use to evaluate your potential return on investment or asset.
While CAPM is a valuable financial metric in understanding the relationship between risk and return, it has limitations. First, CAPM assumes several figures, such as the risk-free rate and market value. As these fluctuate and change, the actual value may not be represented within the formula. CAPM is designed for equity investments, but using it for fixed-income securities will yield incorrect values.
Additionally, beta estimation considers historical data — however, history isn’t always the best predictor of present or future doings. Also, market anomalies exist because the model assumes all information is immediately shown in market pricing. And while the model considers systematic risk, it does not consider other factors influencing asset returns, like firm value.
Although there are several limitations, CAPM is still a valuable tool in the toolbox for evaluating investments and identifying risk.
Because CAPM has several limitations that can change its actual value, it’s more effective when used with other business valuation methods.
While you cannot predict every limitation that the CAPM formula could have, there are some tips you can use to make its value the most accurate:
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