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How Do I Use the CAPM to Determine Cost of Equity?

What Is the Capital Asset Pricing Model (CAPM)?

In capital budgeting, corporate accountants and financial analysts often use the capital asset pricing model (CAPM) to estimate the cost of shareholder equity. Described as the relationship between systematic risk and expected return for assets, CAPM is widely used for the pricing of risky securities, generating expected returns for assets given the associated risk, and calculating costs of capital.

Key Takeaways

• The capital asset pricing model (CAPM) is used to calculate expected returns given the cost of capital and risk of assets.
• The CAPM formula requires the rate of return for the general market, the beta value of the stock, and the risk-free rate.
• The weighted average cost of capital (WACC) is calculated with the firm's cost of debt and cost of equity—which can be calculated via the CAPM.
• There are limitations to the CAPM, such as agreeing on the rate of return and which one to use and making various assumptions.
• There are online calculators for determining the cost of equity, but calculating the formula by hand or by using Excel is a relatively simple exercise.

Formula and Calculation of the Cost of Equity

The CAPM formula requires only the following three pieces of information: the rate of return for the general market, the beta value of the stock in question, and the risk-free rate.

\begin{aligned} &Ra=Rrf+\left [Ba*\left ( Rm-Rrf\right) \right ] \\ &\textbf{where:}\\ &Ra=\text{Cost of Equity}\\ &Rrf=\text{Risk-Free Rate}\\ &Ba=\text{Beta}\\ &Rm=\text{Market Rate of Return}\\ \end{aligned}

Rate of return refers to the returns generated by the market in which the company's stock is traded. Often, the long-term rate of return of the market is considered the market rate of return. The beta of the stock refers to the risk level of the individual security relative to the broader market.

A beta value of "one" indicates that the stock moves in tandem with the market. If the S&P 500 gains 5%, so does the individual security. A higher beta indicates a more volatile stock, and a lower beta reflects greater stability.

The risk-free rate is generally defined as the (more or less guaranteed) rate of return on short-term U.S. Treasury bills, because the value of this type of security is extremely stable, and the return is backed by the U.S. government. So, the risk of losing invested capital is virtually nil, and a certain amount of profit is guaranteed.

What the CAPM Can Tell You

The cost of equity is an integral part of the weighted average cost of capital (WACC), which is widely used to determine the total anticipated cost of all capital under different financing plans in an effort to find the most cost-effective mix of debt and equity financing.

Assume Company ABC trades on the S&P 500 with a rate of return of 9%. The company's stock is slightly more volatile than the market with a beta of 1.2. The risk-free rate based on the three-month T-bill is 4.5%.

Based on this information, the cost of the company's equity financing is:

$4.5+1.2*\left(9-4.5\right)\text{= 9.9\%}$

Numerous online calculators can determine the CAPM cost of equity, but calculating the formula by hand or by using Microsoft Excel is a relatively simple exercise.

The Difference Between CAPM and WACC

The CAPM is a formula for calculating cost of equity. The cost of equity is part of the equation used for calculating the WACC. The WACC is the firm's cost of capital, which includes the cost of the cost of equity and cost of debt.

Limitations of Using CAPM

There are some limitations to the CAPM, such as agreeing on the rate of return and which one to use. Beyond that, there’s also the market return, which assumes positive returns, while also using historical data. This includes the beta, which is only available for publicly traded companies. The beta also only calculates systematic risk, which doesn’t account for the risk companies face in various markets.

There are also various assumptions that must be made, including that investors can borrow money without limitations at the risk-free rate. The CAPM also assumes no transaction fees, that investors own a portfolio of assets, and that investors are only interested in the rate of return for a single period—all of which are not always true.

Cost of Equity CAPM FAQs

Is CAPM the Same As Cost of Equity?

CAPM is a formula used to calculate the cost of equity—the rate of return a company pays to equity investors. For companies that pay dividends, the dividend capitalization model can be used to calculate the cost of equity.

How Do You Calculate Cost of Equity Using CAPM?

The CAPM formula can be used to calculate the cost of equity, where the formula used is:

Cost of equity = risk-free rate of return + beta * (market rate of return - risk-free rate of return)

What Are Some Potential Problems When Estimating the Cost of Equity?

The biggest issues when estimating the cost of equity include measuring the market risk premium, the beta to use, and using short- or long-term rates for the risk-free rate.

How Are CAPM and WACC Related?

WACC is the total cost cost of all capital. CAPM is used to determine the estimated cost of the shareholder equity. The cost of equity calculated from the CAPM can be added to the cost of debt to calculate the WACC.

The Bottom Line

For accountants and analysts, CAPM is a tried-and-true methodology for estimating the cost of shareholder equity. The model quantifies the relationship between systematic risk and expected return for assets and is applicable to a multitude of accounting and financial contexts.