CAPM stands for the Capital Asset Pricing Model. It is a widely used financial model that helps investors and analysts calculate the expected return on an investment, particularly a stock, based on its risk and the expected return of the overall market.
FORMULA —> ke=Rf+β×(Rm−Rf)
Where:
ke = Expected return of the stock Rf = Risk-free rate of return
β = Beta of the stock
Rm = Expected return of the market
Understanding CAPM:
The CAPM model suggests that the expected return of a stock should be the risk-free rate plus a risk premium, which is determined by the stock’s beta and the market risk premium.
If a stock has a higher beta, it is expected to have a higher return because it is riskier than the market.
Conversely, if a stock has a beta lower than 1, it is considered less risky than the market, and its expected return would be lower than the market return.
CAPM is used extensively in finance to calculate the cost of equity for a company. This cost of equity is then used as a discount rate in various valuation models, such as discounted cash flow (DCF) analysis.
However, it’s essential to note that CAPM has its critics and limitations. Some criticisms include its reliance on historical data, the assumption of a linear relationship between risk and return, and the assumption that all investors have the same expectations and access to the same information.
Despite its limitations, CAPM remains a valuable tool in finance for estimating the expected return on an investment, especially in the context of understanding the risk- return tradeoff in the stock market.