Capital Asset Pricing Model (CAPM) & Cost of Equity (CoE)
Also called CAPM · CoE
The CAPM is a north star formula that is used to calculate the Cost of Equity (CoE). It’s essentially an estimation of the expected return on an investment by accounting for its systematic risk, measured as beta, and comparing it to the risk-free rate and the overall market’s expected return.
It is used to calculate the Cost of Equity (CoE) because it quantifies the return that equity investors require for taking on the risk of investing in a company.
Formula
We’re going to hop into an example in a second but here are some quick definitions (with links to more fulsome definitions):
Risk-Free Rate: A measure of the return that a security with minimal risk would perform. Typically this is the yield on a 10-year US Treasury Bond.
Beta: A measure of the investment’s systematic risk relative overall to the market.
Market Return: The expected return of the overall market, representing a benchmark for average returns.
rm - rf: This expression is called the Market Risk Premium and encapsulates the reward for assuming systematic risk. Essentially, relative to the risk-free rate, how much additional return is the market expected to provide to compensate for the additional risk?
Example
If we wanted to use CAPM formula to calculate the Cost of Equity for FlowerCentral, it would look like this:
You’ll notice that we’ve done the full formula as well as use the shorthand formula using the Market Risk Premium. You want to be fluent in both of these, although we recommend answering the question: “What is the CAPM formula?” by saying “The Risk-Free Rate + Beta * the Market Risk Premium”, as opposed to listing out the entire formula as it demonstrates greater fluency.
In the room
CAPM is the formula you're most likely to be asked to recite outright. Answer it as "risk-free rate plus beta times the market risk premium" — the shorthand reads as fluency, while listing every term reads as memorization.