The capital asset pricing model (CAPM) is used to express the relationship between risk and expected return when pricing stocks. Before an investor buys stock, he compares the required rate of return to the expected rate of return. If the expected rate of return, which is calculated using the CAPM formula, is less than the investor's required rate of return, the investor should not put money into the investment. In general, calculating CAPM can help decide whether investing in a specific stock is worth the risk.
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Write down the formula. The CAPM formula is: r = Rf + Beta --- (RM-Rf). In this formula, r is the expected rate of return, Rf is the risk-free rate and RM is the expected market rate of return.
Determine the risk-free rate. The risk-free rate is the return you would receive on investments with the lowest risk. Investors typically used rates from government treasury bonds. Once you determine the rate, plug it into the "Rf" spots in the formula.
Determine the beta of the stock. A stock's beta reflects the volatility compared with the overall risk of the stock market. Beta can be found on financial websites such as CNBC, Bloomberg or Yahoo Finance. Enter the stock's ticker symbol in the quotes box, and all the stocks information will be displayed, including beta. Plug the number in the "Beta" spot of the formula.
Determine the expected market rate of return. The market rate of return is the rate at which an overall market, such as the S&P 500 or Dow Jones, will grow. This is calculated at your discretion. For example, if you plan to hold a stock for the next five years, and over the past five years the S&P 500 grew at a rate of 15 per cent, the market rate of return would equal 15 per cent. Once you decide what rate to use, plug it into the "RM" spot of the formula.
Complete the computation of the formula with the numbers inserted. The result equals the expected rate of return (r) for your investment. If it is the same or higher than your required rate of return, the CAPM suggests you should invest; if it is lower, you should not invest.
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