What is CAPM?
The Capital Asset Pricing Model, developed independently by William Sharpe, John Lintner, and Jan Mossin in the 1960s, expresses expected return as: E(R) = Rf + beta x (Rm - Rf), where Rf is the risk-free rate, Rm is the expected market return, and beta measures sensitivity to market movements. If the risk-free rate is 4%, the market premium is 6%, and a stock's beta is 1.3, CAPM predicts an expected return of 11.8%.
Practical Applications
Corporate finance teams use CAPM to estimate the cost of equity when evaluating capital projects. Investment analysts apply it to determine whether a stock is overvalued or undervalued relative to its risk. If a stock with a beta of 0.8 is returning 12% while CAPM predicts 8.8%, the 3.2 percentage points of excess return suggest the stock may be mispriced or the manager is generating genuine alpha. CAPM also underpins the construction of the Security Market Line, which plots expected return against beta for all assets.
Key Considerations
CAPM assumes investors hold perfectly diversified portfolios, can borrow at the risk-free rate, and that markets are frictionless. These assumptions rarely hold in practice. Empirical anomalies such as the size effect (small stocks outperforming) and the value premium (cheap stocks outperforming) are not captured by CAPM's single-factor framework. Multi-factor models like the Fama-French three-factor and five-factor models address these shortcomings by adding size, value, profitability, and investment factors.