The capital asset pricing model (CAPM) is sometimes used to estimate the required rate of return

for any firm with publicly traded stock. The CAPM is based on the premise that the only
important risk of a firm is systematic risk, or the risk that results from exposure to general stock
market movements. The CAPM is not concerned with so-called unsystematic risk, which is
specific to an individual firm, because investors can avoid that type of risk by holding diversified
portfolios. That is, any particular adverse condition (such as a labor strike) affecting one
particular firm in an investor’s stock portfolio should be offset in a given period by some
favorable condition affecting another firm in the portfolio. In contrast, the systematic impact of
general stock market movements on stocks in the portfolio cannot be diversified away because
most of the stocks would be adversely affected by a general market decline.

The CAPM suggests that the return of a stock (Rj) is influenced by the prevailing risk-free rate
(Rf), the market return (Rm), and the beta (Bj), as follows:

Rj = R t + B j ( R m – Rt )

where Bj is measured as the covariance between Rj and Rm, which reflects the asset’s sensitivity
to general stock market movements. The CAPM implies that, given a specific Rf and Rm,
investors will require a higher return on a stock that has a higher beta. A higher beta implies a
higher covariance between the stock’s returns and market returns, which reflects a greater
sensitivity of the stock’s return to general market movements.

Estimating the Market Risk Premium The yield on newly issued Treasury bonds is commonly
used as a proxy for the risk-free rate. The term within parentheses in the previous equation is the
market risk premium: the return of the market in excess of the risk-free rate. Historical data for
30 or more years can be used to determine the average market risk premium over time. This
serves as an estimate of the market risk premium that will exist in the future. However, in some
periods, the market risk premium may be higher than in other periods.

EXAMPLE During the financial crisis, there was much uncertainty surrounding the valuations of
stocks in general. Some investors were only willing to maintain investments in the stock market
if the market risk premium was sufficiently high to compensate them for the risk of investing in
the stock market. That is, prices of all stocks in the market had to be sufficiently discounted in
order to offer sufficient upside potential to attract investors. In some other periods when stock
market conditions are very favorable, investors may not be as concerned about the risk of the
stock market in general. In these periods, investors do not require such a large market risk
premium, as they do not fear that the market is susceptible to a major decline.

Estimating the Firm’s Beta A stock’s beta is typically measured by applying regression analysis
to determine the sensitivity of the asset’s return to the market return based on monthly or
quarterly data over the last four years or so. The stock’s return is the dependent variable, and the
market’s return (as measured by the S&P 500 index or some other suitable proxy) is the
independent variable over those same periods.
A computer spreadsheet package such as Excel can be used to run the regression analysis. This
analysis focuses specifically on estimating the slope coefficient, which represents the estimate of
each stock’s beta (see Appendix B for more information on using regression analysis). If the
slope coefficient of an individual stock is estimated to be 1.2, this means that, for a given return
in the market, the stock’s expected return is 1.2 times that amount. The estimated betas for many
stocks are reported on many financial websites and in investment services such as Value Line,
and betas can be computed by the individual investor who understands how to apply regression
analysis. Since a stock’s sensitivity to market conditions may change over time in response to
changes in the firm’s operating characteristics, the stock’s beta may also change over time.

Application of the CAPM

Given the risk-free rate as well as estimates of the firm’s beta and the market risk premium, it is
possible to estimate the required rate of return from investing in the firm’s stock. EXAMPLE
The beta of the stock for Vaxon, Inc., is estimated as 1.2 according to the regression analysis just
explained. The prevailing risk-free rate is 6 percent, and the market risk premium is estimated to
be 7 percent based on historical data. A stock’s risk premium is computed as the market risk
premium multiplied by the stock’s beta, so Vaxon stock’s risk premium (above the risk-free rate)
is 0.07 × 1.2 1⁄4 8.4 percent. Therefore, the required rate of return on Vaxon stock is

Rj = 6% + 1.2(7%)

=14.4%

Because the required rate of return on this stock is 14.4 percent, Vaxon’s estimated future cash
flows can be discounted at that rate when deriving the firm’s present value. At any given time,
the required rates of return estimated by the CAPM will vary across stocks because of
differences in their risk premiums, which are due to differences in their systematic risk (as
measured by beta).