Pronounced as though it were spelled cap-m, this model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe. CAPM describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities. CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. If this expected return does not meet or beat our required return, the investment should not be undertaken.
The commonly used formula to describe the CAPM relationship is as follows:
Required (or expected) Return = RF Rate + (Market Return – RF Rate)*Beta
For example, let’s say that the current risk free-rate is 5%, and the S&P 500 (“the market”) is expected to return 12% next year. You are interested in determining the return that Joe’s Oyster Bar Inc. (JOB) will have next year. You have determined that its beta value is 1.9. The overall stock market has a beta of 1.0, so JOB’s beta of 1.9 tells us that it is more risky than the overall market; this extra risk means that we should expect a higher potential return than the 12% of the S&P 500. We can calculate this as the following:
Required (or expected) Return = 5% + (12% – 5%)*1.9
Required (or expected) Return = 18.3%
What CAPM tells us is that Joe’s Oyster Bar has a required rate of return of 18.3%. So, if you invest in JOB, you should be getting at least 18.3% return on your investment. If you don’t think that JOB will produce those kinds of returns for you, then you should consider investing in a different company.
It is important to remember that high-beta shares usually give the highest returns. Over a long period of time, however, high beta shares are the worst performers during market declines (bear markets). While you might receive high returns from high beta shares, there is no guarantee that the CAPM return is realized.