What is CAPM? Formula, examples, and applications

The Capital Asset Pricing Model (CAPM) shows whether an investment’s potential return justifies its risk. By linking expected return to systematic risk, it helps investors and finance teams evaluate stocks, bonds, and capital projects on equal footing.

The CAPM formula connects three key variables: the risk-free rate, an asset’s beta, or its volatility relative to the market, and the market risk premium. Together, they estimate the return an investor should expect to receive in exchange for taking on that level of risk.

In practice, CAPM supports better decision-making in corporate finance, portfolio management, and valuation. It’s the foundation for setting hurdle rates, calculating cost of equity, and benchmarking performance across investments.

What is the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a framework that calculates an investment’s expected return based on its systematic risk relative to the overall market. It shows what return investors should require given the risk level, compared with a risk-free rate such as a U.S. Treasury bill or bond.

CAPM focuses on systematic risk, a type of risk that can’t be eliminated through diversification. This includes broad economic shifts, interest rate changes, and global events that affect the entire market. The model assumes that investors already hold a diversified portfolio, so company-specific or unsystematic risks are not part of the equation.

By providing a consistent way to compare risk and return across investments, CAPM has become a cornerstone of modern portfolio theory. Finance professionals use it in valuation, capital budgeting, and portfolio management to decide whether an opportunity’s potential reward justifies its level of market risk.

CAPM vs. other asset pricing models

CAPM differs from other asset pricing models by focusing on a single source of risk: systematic market risk. Other models use multiple risk factors to explain returns, but CAPM relies only on beta to measure an asset’s sensitivity to the overall market. This makes it easier to calculate, but sometimes less precise than multi-factor alternatives.

The model assumes you hold a diversified portfolio, which eliminates company-specific risks. This simplification separates CAPM from approaches that consider industry characteristics or unique firm variables.

Single-factor model

CAPM uses one risk factor, the market portfolio, to estimate expected returns. Beta measures how sensitive an investment is to overall market movements. For example, a stock with a beta of 1.5 tends to move 50% more than the market. When the market rises 10%, that stock typically rises 15%.

This single-factor approach requires only three inputs: the risk-free rate, beta, and the market risk premium. It provides a direct link between risk and return, which makes CAPM a practical tool for financial modeling and valuation.

Multi-factor models

The Fama-French models expand on CAPM by adding size, value, profitability, and investment factors to explain returns. The three-factor model includes market risk, company size, and value characteristics, while the five-factor model adds profitability and investment patterns.

These factor models better capture the drivers of stock performance but require more data and assumptions. Analysts need detailed historical information on company size, book-to-market ratios, and financial results to apply them accurately.

Arbitrage pricing theory

Arbitrage pricing theory (APT) allows multiple economic factors to influence expected returns. Each factor has its own beta coefficient, representing sensitivity to that variable. Examples include inflation, GDP growth, and changes in interest rates.

Unlike CAPM, APT doesn’t specify which factors matter most, so analysts must identify them for each market or period. This flexibility lets APT adapt to different capital markets, though it also adds complexity.

The CAPM formula and key variables

The CAPM formula quantifies the relationship between risk and expected return. It shows what investors should earn to compensate for taking on systematic market risk.

By combining these elements, CAPM transforms abstract risk concepts into actionable numbers. Finance teams use the model to calculate cost of capital, set hurdle rates, and compare investment opportunities on a risk-adjusted basis.

The CAPM formula is;

E(Rᵢ) = Rf + βᵢ [E(Rₘ) − Rf]

Where:

• E(Rᵢ) = Expected return on the investment
• Rf = Risk-free rate of return, usually based on Treasury securities
• βᵢ = Beta, a measure of volatility or systematic risk relative to the overall market
• E(Rₘ) = Expected market return
• E(Rₘ) − Rf = Market risk premium, the extra return investors demand for holding risky assets instead of government bonds

Each variable connects theory to practical finance decisions:

Risk-free rate

• Represents the baseline return on an investment with zero credit risk, typically a Treasury bill for short-term analysis or a 10-year Treasury bond for long-term decisions
• Acts as the foundation for all return expectations in business finance and valuation
• Moves with monetary policy, so analysts update it regularly to keep CAPM calculations accurate

Beta

• Measures how much an asset’s returns move compared with the stock market
• A beta of 1.0 moves in line with the market; above 1.0 means higher volatility, and below 1.0 means lower volatility
• A higher beta signals higher risk and, therefore, a higher required return
• Financial analysts often estimate beta using regression analysis of historical returns or pull it from data providers

Market risk premium

• Represents the additional return investors expect for taking on market risk instead of staying in risk-free assets
• Calculated as expected market return minus the risk-free rate
• Typically averages 6–8% annually in the U.S., but varies with interest rates, growth expectations, and market volatility
• Essential for setting cost of equity and discount rates in investment valuation, including net present value calculations

Expected return

• Combines the risk-free rate and risk premium to determine the required rate of return for an asset
• Provides a benchmark to decide if an investment’s potential payoff compensates for its level of systematic risk
• Used in everything from capital budgeting to portfolio management and WACC calculations

Systematic vs. unsystematic risk

• Systematic risk affects the entire capital market (economic cycles, inflation, policy changes)
• Unsystematic risk is company-specific and can be reduced through diversification
• CAPM focuses only on systematic risk because it assumes a diversified portfolio

How to calculate expected return using CAPM

Using the CAPM formula turns market data into an actionable expected return. The model converts theoretical concepts like market risk and volatility into a concrete required rate of return that guides investment and valuation decisions.

1. Gather accurate inputs

Start by identifying the key data points for your calculation. The risk-free rate represents the return on a government bond with no default risk. Use the yield on a Treasury bill for short-term analysis or a 10-year Treasury bond for long-term decisions.

Next, find your asset’s beta (β), which measures how much it moves relative to the market portfolio. A beta above 1.0 indicates higher volatility than the market, while a beta below 1.0 suggests lower volatility.

Finally, determine the expected market return (E(Rₘ)) based on long-term stock market performance or forward-looking forecasts. Many financial analysts use 8–10% as a reference range for the U.S. equity market, though the figure can vary by time period, economic cycle, and market conditions.

2. Plug in the numbers

Insert the inputs into the CAPM formula:

E(Rᵢ) = Rf + βᵢ [E(Rₘ) − Rf]

For example:

E(Rᵢ) = 4% + 1.2 * (10% − 4%) = 11.2%

The result shows your expected return or required rate of return of 11.2%. This is the minimum annual return an investor should demand to justify the investment’s systematic risk.

3. Interpret and apply the results

Use this output to assess whether an investment meets your performance targets or the company’s cost of capital by projecting free cash flow and comparing it to the CAPM threshold. If the expected return exceeds the CAPM rate, the investment may be undervalued. If it falls short, the potential reward may not justify the risk.

Finance teams apply this analysis when setting hurdle rates, estimating discount rates for future cash flows, and evaluating projects in capital budgeting. The process helps ensure consistency across investment decisions and supports a disciplined approach to risk-adjusted performance.

CAPM example with step-by-step math

Let’s apply the CAPM formula to a real-world scenario. Suppose you want to evaluate whether to invest in TechCorp stock. You’ve collected the following inputs:

• Risk-free rate (Rf): 4.5% based on the 10-year Treasury yield
• Beta (βᵢ): 1.35
• Expected market return (E(Rₘ)): 11%

First, calculate the market risk premium:

E(Rₘ) − Rf = 11% − 4.5% = 6.5%

Next, plug the values into the CAPM formula:

E(Rᵢ) = Rf + βᵢ [E(Rₘ) − Rf]

E(Rᵢ) = 4.5% + 1.35 * 6.5% = 13.28%

Your result shows that TechCorp must generate at least 13.28% annual returns to compensate for its systematic risk. If your fundamental analysis projects a 15% rate of return, the stock exceeds the required rate of return by nearly 2 percentage points and appears attractive.

However, if the expected return is 12%, the stock doesn’t meet the CAPM threshold. In that case, TechCorp’s risk-adjusted return may not justify the investment.

This CAPM calculation gives you a clear hurdle rate for comparing TechCorp with other opportunities. Any investment with similar beta should meet or exceed this rate to be worth pursuing.

When to use CAPM in finance

Finance teams rely on the Capital Asset Pricing Model in multiple areas of decision-making. CAPM’s ability to link risk and return makes it a versatile tool for valuation, portfolio management, and capital budgeting. The table below summarizes its key applications.

In every case, CAPM establishes a consistent benchmark for comparing returns across assets with different risk profiles. It simplifies complex tradeoffs into one measure: the required rate of return for a given level of systematic risk.

Limits and assumptions of CAPM

The CAPM offers an elegant framework for linking risk and return, but its simplicity depends on assumptions that don’t always hold true in the real world. Recognizing these limits helps finance teams apply CAPM effectively and avoid overreliance on theoretical results.

Together, these limitations explain why CAPM is most useful as a benchmark rather than a precise predictor of returns. It provides valuable structure for decision-making, as long as you adjust its assumptions to fit real-world conditions.

Diversified investors

• CAPM assumes all investors hold perfectly diversified portfolios, eliminating unsystematic risk
• In practice, many investors concentrate holdings in a few companies or industries, exposing them to company-specific risk that CAPM ignores
• This means the model can understate the required rate of return for underdiversified investors

Perfect markets

• The model assumes no transaction costs, taxes, or borrowing constraints
• Real-world markets involve trading fees, capital gains taxes, and borrowing limits that prevent investors from earning the theoretical risk-free rate
• These frictions create gaps between CAPM predictions and achievable returns

Stable betas

• CAPM assumes beta remains constant, but a company’s risk profile often changes over time
• Shifts in business strategy, leverage, or market conditions can make historical betas unreliable
• Finance teams often use adjusted betas or forward-looking estimates to improve accuracy

Market portfolio abstraction

• CAPM assumes investors can hold a true market portfolio of all assets in the economy
• Because that portfolio isn’t observable, analysts use broad indexes as proxies, which introduces error

Investor behavior

• The model assumes investors are rational and risk-averse, evaluating opportunities only by expected return and volatility
• In practice, behavioral biases and financial liquidity needs can cause deviations from CAPM’s predictions

Putting CAPM to work with Ramp

The Capital Asset Pricing Model gives finance teams a structured way to compare investments on a risk-adjusted basis. By pairing expected returns with measurable risk, it helps maintain discipline in capital budgeting, portfolio evaluation, and corporate valuation.

Modern finance teams extend CAPM’s principles through technology. That's where Ramp can help. Accounting automation software and real-time reporting dashboards reduce manual work, minimize data errors, and provide instant visibility for more accurate modeling. Instead of gathering numbers by hand, your team can focus on interpreting results and making strategic decisions.

Try an interactive demo to learn more about how Ramp can help your team make better financial decisions faster.