Risk and expected return
Investors expect to be paid for taking risk. The capital asset pricing model (CAPM), developed in the 1960s by William Sharpe and others, says that the only risk the market rewards is the risk you cannot diversify away: how much an asset moves with the market as a whole, measured by its beta.
The formula
- Expected return = risk-free rate + β × (market return − risk-free rate)
- Market risk premium = market return − risk-free rate
- Risk premium of the asset = β × market risk premium
Worked example
The 10-year Treasury yields 4.2%, you expect the stock market to return 10%, and the stock has a beta of 1.2.
- Market risk premium = 10 − 4.2 = 5.80%.
- Risk premium of the stock = 1.2 × 5.80 = 6.96%.
- Expected return = 4.2 + 6.96 = 11.16%.
Understanding beta
| Beta | Meaning | Typical examples |
|---|---|---|
| Above 1 | Moves more than the market | Technology, consumer discretionary |
| About 1 | Moves with the market | Broad index funds |
| 0 to 1 | Moves less than the market | Utilities, consumer staples |
| Below 0 | Tends to move against the market | Rare; some gold miners at times |
Financial websites publish betas, usually measured against the S&P 500 over 2 to 5 years of returns. Values differ between sources depending on the period and the frequency of data.
Choosing the inputs
- Risk-free rate: the 10-year Treasury yield for long-term valuations, or Treasury bills for short horizons.
- Market risk premium: estimates based on history and surveys of finance professors and CFOs often fall between 4% and 6% for the US.
- Beta: use a published beta, or an industry average when the company’s own beta is noisy.
Uses and limits
CAPM is the standard way to estimate a company’s cost of equity, the first ingredient of the WACC, and the discount rate in valuation models. It is simple but imperfect: studies show that factors such as company size, value and momentum also explain returns, which led to the Fama-French models. Treat the result as an estimate of what investors should demand, not a forecast of what a stock will return.
This calculator gives estimates for education and planning. It is not investment, tax or legal advice; for decisions about your own situation, talk to a qualified financial professional.