The Capital Asset Pricing Model (CAPM) is a financial theory used to determine the expected return on an investment based on its risk in relation to the overall market. The model helps investors assess whether a stock is fairly valued by comparing its expected return to its inherent risk.
The formula for CAPM is:
Expected Return = Risk-Free Rate + Beta × (Market Return − Risk-Free Rate)
Here, the risk-free rate represents the return on a zero-risk investment (like government bonds), beta measures the asset’s volatility compared to the market, and market return is the average return expected from the market portfolio.
CAPM is based on the principle that investors need to be compensated for both the time value of money (risk-free rate) and the risk they take (market risk premium). An asset with a higher beta is considered riskier and should offer higher returns to justify the investment.
Though widely used in portfolio management and valuation, CAPM has limitations, such as assuming a perfectly efficient market and a constant risk-free rate. Still, it remains a foundational concept in modern finance for pricing risky securities and estimating cost of equity.
