Term · Valuation
Capital Asset Pricing Model (CAPM)
In briefThe CAPM estimates the expected return on equity as the risk-free rate plus beta times the market risk premium, thereby providing a cost of equity for valuations. For illiquid small caps, however, beta is often unstable, so the derived cost of capital should be used with caution.
Definition
The CAPM is a model for estimating the expected return on equity as a function of a stock's systematic risk. It adds to the risk-free rate a risk premium derived from beta and the market risk premium. The result often serves as the cost of equity in valuation models.
How it is calculated
Formula. expected return = risk-free rate + beta × (market return − risk-free rate)
Why it matters for small caps
For small caps, the beta required for the CAPM is often unstable because trading data are thin. The resulting cost of equity feeds into DCF valuations and materially affects their outcome.
Common misreadings
- The CAPM beta of illiquid small caps is read as precise, even though it is estimated from limited trading data and can therefore be distorted.
In the process
Frequently asked
What inputs does the CAPM require?
The risk-free rate, the stock's beta, and the market risk premium as the difference between the expected market return and the risk-free rate.
What is the CAPM result used for?
It often serves as the cost of equity and thus feeds into the calculation of the WACC and into DCF valuations.
Why is the CAPM tricky for small caps?
Beta is based on historical price data; with low trading these are thin and the estimated beta correspondingly unreliable.
Related terms
Education only, not investment advice. Ranges and thresholds are didactic orientation values, not an official standard.