The Capital Asset Pricing Model (CAPM) estimates the expected return of an investment based on its sensitivity to market risk. The formula is: expected return = risk-free rate + beta × (market return − risk-free rate). In valuation it is the standard way to estimate a company's cost of equity.
Worked example
Risk-free rate 4%, beta 0.9, market return 9%. CAPM expected return = 4% + 0.9 × (9% − 4%) = 4% + 4.5% = 8.5%.
Why it matters
CAPM isolates the only risk the model says investors are paid for — undiversifiable market risk, captured by beta. It is widely used precisely because it needs only three inputs, all of which are observable.
Frequently asked questions
It assumes beta fully captures risk and that historical relationships hold in future, both of which are imperfect. It remains a useful starting estimate rather than a precise answer.