What It Means
Among the most widely used cost of capital models, CAPM calculates the required rate of return on investment in a specific business as a simple sum:
- A risk-free rate of return
- A risk premium associated with the investment
The equation below shows how CAPM works:
The risk-free rate of return rf is what business owners can obtain by investing in an asset that produces a steady income and has no risk of default. Typically, interest paid by government guaranteed debt securities, such as the US Treasury notes, is considered essentially risk-free.
The risk premium in the CAPM is the product of the extra return P expected from investments in stocks of public companies multiplied by a weighting factor, known as beta. Beta reflects the degree to which investment in the specific business follows the overall market pattern of business investments.
Beta value indicates the level of business risk
If the business earnings go up and down exactly in line with the overall business market behavior, then investing in such a business is just as risky as investing anywhere else in the market. The risk premium for such a business is equal to the overall market risk premium, hence the beta is 1.
A more risky company will tend to produce higher returns when business is good, but may perform worse on average when business conditions deteriorate. Not surprisingly, the business owners will demand a higher rate of return to continue investing in such a company. CAPM accounts for this additional return through the beta value that is greater than 1.
The converse is also true: for a low-risk firm, the business owners can accept lower returns. Hence, this type of company will have a lower beta value, resulting in a lower risk premium above the risk-free rate of return. In particular a value of beta below 1 means that the business is less risky than the business market in general.
CAPM establishes the well-known Security Market Line which captures this risk-return relationship. The line starts at the risk-free rate of return for which beta is equal to 0. For the business investment market in general, beta equals 1. This corresponds to the risk premium for the market as a whole. As beta increases, the line continues upward indicating higher rates of return required for riskier business investments.