In finance, the Capital Asset Pricing Model, or CAPM, is used to determine the relationship between the risk of a stock and its expected return. It’s a fairly complex formula, but it can help you decide whether a risky investment is worth it. Here’s how to calculate the CAPM.
You can calculate CAPM with this formula:X = Y + (beta x [Z-Y])In this formula:X is the return rate that would make the investment worth it (the amount you could expect to earn per year, in exchange for taking on the risk of investing in the stock).Y is the return rate of a “safe” investment, such as money in a savings account.Beta is a measure of a stock’s volatility. We’ll get into beta in more detail in Step 2.Finally, Z is the rate of return of the market in general.
Learn a bit more about beta, since it’s key to the CAPM. The market in general (as measured by the S&P 500) has a beta of 1.0, and a stock’s beta is measured in comparison to the market. So a stock with a beta of 4.0 is four times as volatile as the market. You can find a stock’s beta by searching for its ticker symbol at Reuters.com.
Try a sample CAPM calculation. For this example, we’ll use the following values:Y = 3 percent (the rate of return of ING Direct’s high-interest savings account)Beta = 0.92 (Microsoft’s beta according to Reuters)Z = 10 percent (the stock market’s average annual return)So the equation looks like this:3 + (0.92 x [10-3]) = 9.44.Therefore, Microsoft’s CAPM is 9.44 percent.
So what does this mean? Basically, this tells you that Microsoft would have to earn 9.44 percent a year for it to be worth the risk of investing in, at least according to the CAPM formula. Microsoft’s beta is less than 1, meaning it’s actually less volatile than the market in general, which makes sense since it’s such a large, established company. Let’s see how it looks with a fictional company that’s much more volatile.
Calculate the CAPM for an imaginary company with a beta of 3.5:3 + (3.5 x [10-3]) = 27.5.This company would need to earn you 27.5 percent a year for it to be worth the risk of investing under the CAPM model.
Tip
You can use your own estimations for Y and Z in this equation. For example, if you think the market is likely to return 8 percent per year rather than 10 percent, use that for Z. If you have a savings account that would pay you 5 percent on your cash, use Y.
