Capital Asset Pricing Model

Developed by William Sharpe, John Lintner, and Jan Mossin, the Capital Asset Pricing Model (CAPM) formalizes the relationship between systematic risk and expected return. It posits that investors should only be compensated for non-diversifiable risk.

The CAPM Equation

Components

• E(R_i): Expected Return of the investment. This is often used as the Cost of Equity in WACC calculations.
• R_f: Risk-Free Rate. The theoretical return of an investment with zero risk, practically proxied by the yield on a 10-year US Treasury bond.
• β_i (Beta): The measure of an asset's systematic risk relative to the market. A beta of 1 implies the asset moves exactly with the market. Beta > 1 implies higher volatility; Beta < 1 implies lower volatility.
• [ E(R_m) - R_f ]: The Equity Risk Premium (ERP). The excess return expected from the overall market above the risk-free rate.

Unlevering and Relevering Beta

When applying CAPM to private companies or adjusting for different capital structures, analysts must "unlever" the beta of comparable public companies to remove the effects of debt, find the median unlevered beta, and "relever" it based on the target capital structure.