CAPM: An Overview

Many investors use the capital asset pricing model (CAPM) as a way to estimate the potential return of a stock or other asset within the context of its intrinsic risk. Used primarily to analyze relatively risky investments, CAPM gives the investor a way to evaluate the stock's potential re✅ward given its potential ♐risk and compare it to other alternative investments.

A Microsoft Exce🦹l spreadsheet can be used to calculate CAPM.

CAPM Formula

CAPM is one component of the efficiꦏent market hypothesis, which states that the current prices of assets in a financial market always reflect all of the information available to investors. The logical inference is that investors are unlikely to consistently pick stocks that outperform the wider market.

Calculating CAPM is meant to establish the so-called "efficient frontier." That is, it helps identify the highest potential return for a given level of risk or the lowest level of risk for a desired level of return.

The formula for CAPM calculates the expected return of an asset (usually a stock) with the incorp♈oration of several factors.

The CAPM formula is as follows:

As shown from the above equation, 澳洲幸运5开奖号码历史查询:CAPM involves the risk-free rate of an investment like a U.S. Treasury bond, an asset’s ♏beta, and the expected return of the market.

It is important to ensure that these values are al♉l taken from the same time period. Here we use a 10-year time period.

To calculate an asset's expected return, start with a risk-free rate (the yield on the 澳洲幸运5开奖号码历史查询:10-year Treasury), then add an adjusted premium. The adjusted premium added to the ♐risk-free rate is the difference in the expected ꦚmarket return times the beta of the asset.

♑ This formula can be calculated in Microsoft Excel as sh🐻own below. 

Understanding the CAPM

CAPM provides an 澳洲幸运5开奖号码历史查询:expected return on the as🌊set in focus. This expected return can be an important value for an investor when considering an investment.

Generally, the expected r🔜eturn matches the period of time used to find the expected market return. For example, the market may be expected to retur🐻n 8% over ten years. Thus, the expected return of the stock is also calculated over ten years.

The CAPM is only an estimate and has several caveats. Mainly, the factors used in the CAPM calculation are not static. The 澳洲幸运5开奖号码历史查询:risk-free rate, beta, and market risk premium all change nearly every day and will change more substantially in different market periods and environments or at least on an annual basis.

The CAPM is an important statistic, but it is not always best used on its own. That’s why it forms the basis for the 澳洲幸运5开奖号码历史查询:efficient market hypothesis and the building of an efficient fron💫tier curve.

Efficient Frontier Curves

An efficient frontier curve involves the integration of multiple assets and all of their expected returns. The 澳洲幸运5开奖号码历史查询:efficient frontier uses CAPM 🎀to help create an efficient portfolio that tells an investor the optimal percentage of investment in each asset that will create the best theoretical return for a defined level of risk.

It's worth noting that CAPM is not always fully realized because any investor striving for a balanced portfolio would not devote the entire portfolio to a single asset.

Calculating CAPM in Excel

Now let’s assume you want to find the CAPM of a stock you are interested in investing in. Let’s assume the stock is Tesla (TSLA). First, you want to .

By setting it up in the following format, you leave yourself the opportunit𒀰y to build it out to create an efficient frontier curve and to analyze and compare the expected return of multiple assets or add other comparison metrics.

As you can see, the calculation is built with assumptions at the top that can be adjusted easily when changes are needed. This allows easy updates to the spreadsheet when assumptions ಌchange.🥃

We assume a risk-free rate of 1% on the 10-year Treasury and a market return of 8% on the S&P 500 over 10 years. The 澳洲幸运5开奖号码历史查询:S&P 500 is typically the best benchmark to use since most 澳洲幸运5开奖号码历史查询:beta calculations are based on the S&P 500.

Example of CAPM Calculation

We find that Tesla has a ⛎beta of 0.48. The table also includes standard deviation which is the next data component needed when building out the efficient frontier.

To find the expected return of Tesla we use the CAPM e🍨quation ♈modified for Excel syntax as follows:

• =$C$3+(C9*($C$4-$C$3))

This translates to risk-free plus (beta times the market premium). Using the $ sign helps keep the assumptions static so that you can easily copy⛦ the formula to the right for multiple assets.

In t♉his case, we get an expected return of 4.36% for Tesla.

With this spreadsheet, we can now build out to the right for multiple assets. Say we want to compare Tesla to General Motors (GM). We can simply copy the formula in꧟ C1﷽0 to the right in D10. Then all we need to do is add in the beta for GM in cell D9.

We find a b✤eta of 1.30 which gives us an expected ret♔urn of 10.10%.

Investment Analysis

As shown by this example, there is a big difference between Tesla's 4.36% and General Motors' 10.10%. This mostly comes from the higher beta for General Motors vs. Tesla.

Broadly, this means that a💟n investor is more highly compensated through return for taking on more risk than the market. Thus, the expected return values are generally best viewed alongside beta as a measure of ri🗹sk.

The Bottom Line

An efficient frontier🎐 takes multiple stock investing to the next level by seeking to plot the allocation of multiple stocks in a portfolio.

There are other metrics like the 澳洲幸运5开奖号码历史查询:Sharpe Ratio which can be more easily used to help an investꦓor gauge the risk-reward of one stock vs. another𓃲.