What Is CAPM? Cost of Equity Formula and Example

Mohammed Aamir ShaikhFounder, Aamir Capital

Updated 5 October 20263 min read

The short answerThe cost of equity is the return shareholders expect for owning a business. The capital asset pricing model (CAPM) is the most common way to estimate it. It starts with a risk-free return and adds a premium for the business's market risk, measured by beta.

How it works

CAPM says the return you should expect from a share depends on three things: the risk-free rate, the equity risk premium (the extra return investors want for owning shares in general) and beta (how much this share moves with the market).

For businesses in riskier countries, analysts often add a country risk premium. Practitioners handle it in different ways, so be clear about your approach and keep it consistent.

Cost of equity = Risk-free rate + Beta × Equity risk premium (+ Country risk premium)

A simple example

Risk-free rate 4.0%, beta 1.1, equity risk premium 5.0%. Cost of equity = 4.0% + 1.1 × 5.0% = 9.5%.

How it is used

Finding the cost of equity for WACC.
Valuing the equity of a business directly.
Setting a hurdle rate for an investment.

Common mistakes

Using a risk-free rate in a different currency from the cash flows.
Using an out-of-date equity risk premium.
Using the beta of a single company.
Ignoring country risk for emerging markets.

Questions

What is the risk-free rate?

The return on an investment with almost no chance of default, usually the yield on a long-term government bond in the same currency as the cash flows.

Does CAPM work for private companies?

It is widely used for them, with industry betas and sometimes an extra premium for size or illiquidity. The result is an estimate, not a fact.

Keep learning

For education only. This page is general information. It is not financial, investment, legal or tax advice, and it does not take your situation into account.

What is CAPM and the cost of equity?