How does CAPM work and why does it matter for DCF valuation?

Q: What is the CAPM formula and what does each component represent?

The CAPM formula is Cost of Equity equals Risk-Free Rate plus Beta times Equity Risk Premium. The risk-free rate is the return on a default-free government bond. Beta measures a stock s sensitivity to market movements. The equity risk premium is the excess return investors demand for holding equities over risk-free assets. Together they quantify the return shareholders require.

Q: What is beta in CAPM and how is it calculated?

Beta measures a stock s systematic risk, or how much it moves relative to the overall market. A beta of 1.0 means the stock moves with the market, above 1.0 means more volatile, below 1.0 means less. It is calculated by regressing historical returns against market returns, typically using 2-5 years of weekly data. For private companies, you unlever comparable betas and relever to the target s capital structure.

Q: Why is the risk-free rate based on the 10-year Treasury yield?

The 10-year U.S. Treasury yield is used because it approximates the duration of a company s cash flows in a DCF. It represents a default-free return over a meaningful time horizon. Shorter-term rates would understate the opportunity cost of long-duration investments, while the 30-year bond is less liquid and more volatile, making the 10-year the practical standard.

Q: How is the equity risk premium determined?

The equity risk premium (ERP) is the extra return investors demand for holding stocks over risk-free bonds. It is typically estimated at 5-7% using historical excess returns of the S&P 500 over Treasury bonds or through forward-looking approaches based on current market valuations. Most banks use a standardized figure from Duff and Phelps or similar data providers rather than calculating it independently.

Master CAPM for IB interviews: formula, beta, equity risk premium, and why systematic risk is the only risk that gets compensated.

OfferGoblin·4 min read··

"Risk comes from not knowing what you're doing." — Warren Buffett

Concept

The Capital Asset Pricing Model (CAPM) calculates the expected return on an equity investment. It says your required return equals the risk-free rate plus a premium for bearing systematic (market) risk. The premium is your stock's sensitivity to the market (beta) multiplied by the market risk premium. It's the workhorse for calculating cost of equity in DCF valuations.

Intuition

CAPM's core logic: diversification kills idiosyncratic risk, but you can't diversify away the market itself. If you hold 30+ stocks, company-specific disasters wash out. What remains is exposure to the overall economy—recessions, rate shocks, systemic crises. Since you can't escape this systematic risk, the market compensates you for bearing it. Beta quantifies your exposure. Higher beta = more market sensitivity = higher required return. CAPM is just asking: "How much of your returns come from the market, and what premium do you demand for that?"

Components

Risk-Free Rate

What It Is

The return on a theoretically zero-risk investment. In practice, the 10-year U.S. Treasury yield is the standard proxy for dollar-denominated valuations.

How to Calculate It

Look it up. Pull the current yield on the 10-year Treasury. For non-U.S. companies, use the sovereign bond yield in the local currency, or use U.S. rates and adjust for country risk separately.

Key Consideration

Match the duration to your cash flows. A 10-year rate works for most DCFs. For short-term projects, a 2-year Treasury might be appropriate. Never use a 30-day T-bill for a perpetuity valuation.

Beta

What It Is

Beta measures how much a stock moves relative to the market. A beta of 1.0 means the stock moves exactly with the market. Beta of 1.5 means 50% more volatile than the market. Beta of 0.7 means 30% less volatile.

How to Calculate It

Regress the stock's historical returns against market returns (typically S&P 500). The slope coefficient is beta. In practice, you pull it from Bloomberg, Capital IQ, or Yahoo Finance.

For private companies or divisions, use comparable company betas:

Find public comps
Unlever each comp's beta: $β_{u} = \frac{β _{l}}{1 + ( 1 - t ) \times \frac{D}{E}}$
Average the unlevered betas
Relever to target capital structure: $β_{l} = β_{u} \times [1 + (1 - t) \times \frac{D}{E}]$

Key Consideration

Raw beta uses historical data. Adjusted beta (Bloomberg default) nudges it toward 1.0, assuming companies become more average over time: $β_{a d j} = 0.67 \times β_{r a w} + 0.33 \times 1.0$ . Know which one you're using.

Equity Risk Premium

What It Is

The extra return investors demand for holding stocks instead of risk-free bonds. It's the compensation for bearing systematic market risk.

How to Calculate It

Two approaches:

Historical: Average excess return of stocks over bonds. Typically 5-7% for U.S. markets depending on the time period.
Implied: Back-solve from current market prices using expected earnings/dividends. Damodaran publishes this monthly.

Most banks use a range of 5-6% for U.S. equities.

Key Consideration

ERP is the most debated input in CAPM. Small changes materially impact valuation. If someone asks "What ERP do you use?" have a defensible answer: "5.5%, consistent with long-term historical averages" or "Damodaran's current implied ERP."

Interview Script

CAPM calculates the cost of equity as the risk-free rate plus beta times the market risk premium. The logic is that diversification eliminates company-specific risk, but you can't diversify away exposure to the overall market—so investors demand compensation for that systematic risk. Beta measures how sensitive a stock is to market movements, so higher beta means higher required return.

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Frequently Asked Questions

What is the CAPM formula and what does each component represent?

What is beta in CAPM and how is it calculated?

Why is the risk-free rate based on the 10-year Treasury yield?

How is the equity risk premium determined?