Cost of equity · CAPM model
CAPM Formula: How to Calculate the Cost of Equity
CAPM is the standard way analysts compute the discount rate for equity and feeds directly into WACC.
The cost of equity is the return shareholders require to hold the stock — estimated by CAPM as the risk-free rate plus a beta-scaled equity risk premium. CAPM formula: E(R) = Rf + β × (Rm − Rf). Rf = risk-free rate (10-yr Treasury yield). β = stock beta (sensitivity to market). Rm − Rf = equity risk premium (~5–5.5% historical US average). The result is the cost of equity input used in WACC and DCF models.
CAPM Components Explained
Beta below 1 means the stock moves less than the market; above 1 means it amplifies market swings. A defensive utility with β = 0.6 will have a lower cost of equity than a volatile tech stock with β = 1.8, all else equal.
Worked Example: Apple (AAPL)
Using publicly available inputs as of late 2024: Rf = 4.3% (10-yr Treasury), β = 1.25 (Yahoo Finance), ERP = 5.5% (Damodaran):
- Risk-free rate (Rf)
- 4.3%
- Beta (β)
- × 1.25
- Equity risk premium (Rm − Rf)
- 5.5%
- Beta-scaled ERP (1.25 × 5.5%)
- 6.875%
- Cost of equity E(R) = 4.3% + 6.875%
- ≈ 11.2%
This 11.2% is the equity cost component that feeds AAPL's WACC. Because Apple's capital structure is predominantly equity, the WACC will land close to this figure — typically around 9–11% depending on the debt weighting and current tax rate.
When CAPM Understates Risk
- Small-cap premium. Betas on small-cap stocks understate idiosyncratic risk because the underlying volatility is not fully captured by market covariance. Analysts routinely add a 1–3% illiquidity or size premium on top of the CAPM result for sub-$2B companies.
- Country risk. Emerging-market investments carry sovereign risk — political instability, currency devaluation, expropriation — that a US-market ERP does not reflect. Damodaran publishes country risk premiums that can be layered on top of the base ERP.
- Early-stage companies. Pre-revenue or early-growth firms have no stable beta history. The model breaks down because there is no reliable covariance estimate; analyst judgment — scenario-based discount rates, venture-capital method hurdle rates — replaces the formula in practice.
Limitations of CAPM
CAPM assumes a single risk factor — market beta — drives all expected returns. It also assumes returns are normally distributed, that investors hold diversified portfolios, and that the risk-free rate is stable over the investment horizon. None of these assumptions hold perfectly in practice.
The Fama-French three-factor model addresses the first shortcoming by adding a size premium (small companies earn more than large) and a value premium (cheap stocks outperform expensive ones) on top of market beta. For most corporate finance work — DCF models, WACC calculations, capital budgeting — CAPM remains the standard because it is simple, transparent, and defensible. Use it as a baseline with an understanding of where it systematically underfits.