What is Capital Asset Pricing Model?
The Capital Asset Pricing Model (CAPM) calculates the expected return on an asset based on its systematic risk. The formula is: expected return equals the risk-free rate plus beta times the equity risk premium. CAPM is widely used to estimate cost of equity in valuation and capital budgeting.
How It Works
- Start with the risk-free rate, usually a government bond yield.
- Estimate the asset’s beta, a measure of how it moves with the market.
- Multiply beta by the equity risk premium (market return minus risk-free rate).
- Add the result to the risk-free rate to get the required return.
Saudi Context
Saudi analysts often use the yield on long-dated Saudi government sukuk as the risk-free rate and add a regional equity risk premium when estimating cost of equity for Tadawul-listed companies.
Example
If the risk-free rate is 4 percent, beta is 1.2 and the equity risk premium is 6 percent, the required return is 4 + 1.2 x 6 = 11.2 percent.