At a Glance
- CAPM = Capital Asset Pricing Model — the industry-standard formula for cost of equity.
- Formula: Re = Rf + β × (Rm − Rf)
- Risk-free rate (Rf): typically the 10-year US Treasury yield.
- Beta (β): measures a stock’s volatility relative to the broad market.
- Market risk premium (Rm − Rf): historically 4–6% for US equities.
The Formula
| Variable | Name | Typical Source |
|---|---|---|
| Re | Cost of equity (output) | Calculated by CAPM |
| Rf | Risk-free rate | 10-year US Treasury yield (FRED, Bloomberg) |
| β | Beta | Yahoo Finance, Bloomberg, Capital IQ |
| Rm | Expected market return | Historical S&P 500 long-run average (≈ 10%) |
| Rm − Rf | Market risk premium (ERP) | Damodaran’s annual ERP estimates |
Each Variable Explained
Risk-Free Rate (Rf)
The return available with zero credit risk — typically the yield on a 10-year US Treasury bond. It compensates investors purely for the time value of money. As of 2026, the 10-year Treasury yield is approximately 4–4.5%. Always use the current yield, not a historical average.
Beta (β)
Beta measures the stock’s sensitivity to broad market movements. A beta of 1.0 means the stock moves in lockstep with the S&P 500. A beta of 1.5 means it moves 50% more than the market — up and down. A beta of 0.7 means it absorbs only 70% of market swings. Beta values below zero (rare) mean the stock tends to move opposite to the market.
For private companies, use the unlevered beta from a peer group of comparable public companies, then re-lever it for the private firm’s capital structure. This adjusts for the difference in financial risk between the comparable public peers and your target.
Market Risk Premium (Rm − Rf)
This is the extra return investors demand for holding equities over risk-free bonds. The US equity risk premium has historically ranged from 4–6%. Aswath Damodaran (NYU Stern) publishes annual ERP estimates widely used by practitioners. Using a long-run S&P 500 return of ~10% with Rf of 4.5% gives an implied ERP of ~5.5%.
Worked Example
| Input | Value |
|---|---|
| Risk-Free Rate (Rf) | 4.5% |
| Beta (β) | 1.3 |
| Expected Market Return (Rm) | 10.0% |
Interpretation: Equity investors in this company require an 11.65% annual return to compensate for the systematic risk they bear. This figure is then used as Re in the WACC formula.
Common Mistakes
- Using short-term T-bill rates for Rf — CAPM is a long-run model and should use a long-run risk-free rate (10-year Treasury, not 3-month).
- Using a levered beta from a different industry without re-levering — this embeds a different company’s capital structure risk into your model.
- Wrong geography for ERP — the US equity risk premium should not be applied to a company operating primarily in an emerging market; add a country risk premium.
- Treating CAPM output as the full WACC — CAPM gives cost of equity only. You still need to blend it with the cost of debt to get WACC.
- Using historical average Rf — always use the current yield, not a 10-year historical average of Treasury yields.
Related Concepts
FAQ
What if I don’t have a beta for a private company?
Use the median unlevered beta from a group of comparable public peers, then re-lever using the Hamada equation: βL = βU × [1 + (1 − Tc) × (D/E)]. This adjusts for the private company’s specific financial leverage.
Is 10% a reliable market return assumption?
The US equity market has returned approximately 10% nominally over the long run. Forward-looking estimates are often lower given current valuations. Many conservative practitioners use 8–9% for DCF models to avoid overstating terminal values.
Does CAPM work for non-US companies?
Yes, with modifications. Add a country risk premium (CRP) to the base formula to account for political, currency, and economic risk in the target market. Damodaran publishes country risk premium estimates annually for most economies.
What is the difference between levered and unlevered beta?
Levered (equity) beta reflects both business risk and financial risk (the effect of debt). Unlevered (asset) beta strips out the financial risk, isolating business risk only. Unlevered betas are useful for comparing companies with different capital structures on an apples-to-apples basis.
DISCLAIMER: All calculations are illustrative only and do not constitute investment advice.