Enter the expected mark return rate, risk free rate, and Beta for the stock to calculate the return on a capital asset.
The following formula is used by the CAPM to calculate the expected return of an asset or security.
E(Ri) = Rf + [ E(Rm) − Rf ] × βi
- E(Ri) is the expected return on the capital asset (%)
- Rf is the risk-free rate (%)
- E(Rm) is the expected return of the market (%)
- βi is the beta of the security
The beta of the security is another way of saying the risk measure of the security. This will depend on the security, but this averages around a value of 4.
CAPM is a model that is a slight variation on the discounted cash flows model. In short, the only difference is that instead of using a margin of safety like in the discounted cash flows model, this uses a discounted rate dependent on beta.
How to calculate expected return using CAPM
The following example is a step by step guide to determining the expected return of a security use the CAPM.
- The first step is to determine what variables we need to know in order to calculate the expected return. Looking at the formula above, you can see that the risk free rate (%), expected return of the market (%), and the beta must be determined.
- Now, we must determine the risk free rate of a return on capital. This is often consider things like savings accounts and security bonds. For this example we will assume a return of 3%.
- Next, the expected return rate of the market must be determined. This is the return rate of the security in the stock market. We will say 10%.
- Next, the beta of the security must be determined. This is a measure of risk. The higher the beta the higher the risk. We will assume a value of 4 for this example.
- Finally, enter all of the information into the calculator or formula. We find the expected rate of return is 31%.
This is a very large return, and the reason it’s so large is mostly because of the beta we chose of 4. The higher the beta the higher the return, but also the higher the risk.