CAPM and the security market line: required return explained
Investors want to be paid for risk. The capital asset pricing model, CAPM, says exactly how much, and by which kind of risk. It is one of the few ideas in finance that is both simple enough to compute in a line and used constantly: to set the required return on a stock, to price projects, and to judge whether a manager added value.
Two kinds of risk
A share's price moves for two kinds of reason. Some of it moves with the whole market: interest rates, the economy, sentiment. That is systematic risk and it cannot be diversified away. The rest is specific to the company: a product launch, a lawsuit, a change of management. That is unsystematic risk, and holding many different shares makes much of it cancel out.
CAPM's central claim is that the market pays you only for systematic risk. Since you can get rid of the unsystematic kind for free by diversifying, nobody should expect extra return for carrying it.
Beta: measuring the systematic part
An asset's beta is its sensitivity to the market:
β = Cov(asset return, market return) ÷ Var(market return)
The market has a beta of 1. An asset with a beta of 1.5 tends to move one and a half times as much as the market, up or down. A beta of 0 means no relationship, and a negative beta moves against the market, which is rare.
The CAPM equation
The required return is the risk-free rate plus beta times the market's extra return over the risk-free rate, the equity risk premium:
Required return = risk-free rate + β × (expected market return − risk-free rate)
With a risk-free rate of 3%, a beta of 1.2 and an equity risk premium of 5%, the required return is 3 + 1.2 × 5 = 9%. You can try inputs of your own in the WACC and CAPM calculator.
The security market line
Plot required return against beta and CAPM gives a straight line: the security market line, SML. It starts at the risk-free rate where beta is zero and rises with a slope equal to the equity risk premium. Every fairly priced asset sits on the line.
That turns the SML into a tool for spotting mispricing. Compare an asset's expected return, from your own analysis, with the return the SML says it should earn for its beta:
- Expected return above the line: the asset is undervalued, because it offers more than its risk requires. Buy.
- Expected return below the line: the asset is overvalued. Avoid or sell.
The gap between the two is the asset's alpha. An alpha of zero means the asset is fairly priced.
What CAPM assumes, and where it falls short
The model rests on assumptions that are tidy and unrealistic: investors are rational and hold diversified portfolios, they share the same expectations, there are no taxes or costs, and everyone can borrow and lend at the risk-free rate. In practice:
- Beta has to be estimated from history, and the estimate depends on the period, the market index and the return interval you choose.
- A single factor does not explain all differences in average returns, which is why multifactor models exist.
- The market return and the equity risk premium are not observable; they are estimates, and reasonable people differ.
CAPM is still the standard starting point for a required return, as long as you remember it is a model.
Mistakes to avoid
- Using the market return instead of the premium. The formula multiplies beta by the market return minus the risk-free rate.
- Confusing the CAPM line with the capital market line. The SML is plotted against beta and applies to any asset; the capital market line is plotted against total risk and applies to efficient portfolios.
- Treating a high beta as a flaw. It means more systematic risk, which should be paid for with a higher required return.
- Forgetting that beta describes systematic risk only. Two assets with the same beta can have very different total risk.
Where this is tested
CAPM appears in portfolio management and again in equity valuation and corporate finance, where the required return on equity is an input to both a discount rate and the cost of capital. The outcomes below set out how.