The equation that prices a stock's risk
The Capital Asset Pricing Model (CAPM) is the equity-pricing companion to portfolio theory. It says: every stock's expected return depends on its sensitivity to the market. The math:
Read: a stock's expected return equals the risk-free rate plus its beta times the market's expected risk premium.
Three pieces:
r_f= the risk-free rate (Track 3 lesson 6)E(R_m) − r_f= the market risk premium (extra return investors expect for taking market risk)β_i= the stock's beta (next lesson)
What CAPM is saying
Investors only get rewarded for risk they can't diversify away. Idiosyncratic risk (specific to one company) can be diversified — so it doesn't earn extra return. Systematic risk (the part that moves with the whole market) can't be diversified — so it earns a premium.
Beta measures how much of the systematic risk a stock has. β = 1 means moves like the market. β = 1.5 means amplifies the market by 1.5x. β = 0.5 means moves half as much. β = 0 means uncorrelated.
So a high-β stock earns a higher expected return (because it has more market risk), and a low-β stock earns a lower expected return. The exact relationship is the line above.
An example
Suppose r_f = 4%, market risk premium = 6%, and a stock has β = 1.2. Its expected return per CAPM:
E(R_i) = 4% + 1.2 × 6% = 4% + 7.2% = 11.2%
So this stock should be priced to give 11.2% expected return. If it's priced to give 15%, it's "underpriced" by CAPM (market is paying too little for it). If priced to give 8%, it's "overpriced."
This is what active stock-pickers are implicitly doing — finding stocks where actual expected return differs from CAPM-implied expected return. Whether those differences exist consistently is the alpha question (lesson 9-7's EMH covers this).
What CAPM is and isn't
CAPM is:
- The simplest formal model linking risk to expected return
- The standard way of thinking about "what return should I expect from this stock?"
- Cost-of-equity input for DCF (Track 6)
CAPM isn't:
- A perfect predictor (real returns deviate from CAPM frequently)
- The only model — multi-factor models (Fama-French, etc.) extend it
- Always right — its assumptions are idealized
Despite limitations, CAPM is the universal language. Every finance practitioner knows it. Even when they use better models, they explain it in terms of CAPM-relative.
The takeaway
CAPM: E(R_i) = r_f + β × (E(R_m) − r_f). Expected return = risk-free + beta × market premium. Captures the idea that only undiversifiable (market) risk earns premium. β measures market sensitivity (next lesson). Real stock returns deviate from CAPM, but CAPM is the universal benchmark and the cost-of-equity for DCF. Lesson 9-4 unpacks beta in detail.