# What is CAPM (Capital Asset Pricing Model)?

## CAPM Formula

The **Capital Asset Pricing Model**, or **CAPM**, calculates the value of a security based on the expected return relative to the * risk* investors incur by investing in that security.

To calculate the value of a **stock** using CAPM, multiply the **volatility**, known as “beta,”by the additional compensation for incurring risk, known as the “Market Risk Premium,”then add the risk-free rate to that value.

The formula for CAPM is as follows:

=expected return

=“risk-free” rate of interest

=beta (aka volatility – this estimates risk)

=expected return of the market

In layman’s terms, the CAPM formula is:

Expected return of the investment = the risk-free rate + the beta (or risk) of the investment * the expected return on the market – the risk free rate (the difference between the two is the market risk premium).

For each additional increment of risk incurred, the expected return should proportionately increase.

If a security is found to have a higher return relative to the additional risk incurred, then the CAPM model suggests that it is a buying opportunity.

Like all **valuation** models, CAPM has its limitations since some assumptions it uses are idealistic.

For example, Beta coefficients are unpredictable, change over time, only reflect *systemic* risk rather than *total* risk.

Despite its shortcomings, this model is very popular for valuing securities.