How to Calculate Cost of Equity Using CAPM

The capital asset pricing model (CAPM) says the cost of equity equals the risk-free rate plus beta times the equity risk premium. With a 5% risk-free rate, a beta of 1.2 and a 5% equity risk premium, the cost of equity is 5% + 1.2 x 5% = 11%. That 11% is the annual return shareholders need to justify holding the stock.

It’s the most common way to estimate cost of equity for a listed company. You can run the numbers in the CAPM tab of the cost of equity calculator, and this guide walks through each input so you know what you’re typing in.

The CAPM formula

Cost of equity = Risk-free rate + Beta x Equity risk premium
Ke = Rf + Beta x (Rm - Rf)

The equity risk premium is the extra return investors expect from the stock market as a whole over a risk-free bond. Some textbooks write it as (Rm - Rf), the expected market return minus the risk-free rate. Same thing.

Beta scales that premium up or down for the specific stock. A beta of 1.0 means the stock tends to move with the market, so it gets the full premium. A beta of 1.2 means it tends to swing 20% more than the market, so it gets 1.2 times the premium.

If you plot cost of equity against beta, you get a straight line called the security market line. Every stock with the same beta sits at the same required return.

The three inputs and where to find them

Input	Example	Where to find it
Risk-free rate	5%	US Treasury yield curve
Beta	1.2	Regression on stock returns, data providers, industry averages
Equity risk premium	5%	Kroll, Damodaran, or your firm’s house view

Risk-free rate

The risk-free rate is usually a long-term US government bond yield for US dollar valuations. The Treasury publishes the daily par yield curve for every maturity from one month to 30 years.

Most analysts pick the 10-year or the 20-year yield. Short-term bills don’t match the long life of equity cash flows, so they’re rarely used for this.

Beta

Beta measures how much a stock moves when the market moves. It captures systematic risk, the part of risk you can’t diversify away by holding more stocks.

You can calculate it yourself by regressing the stock’s returns against an index (the Excel guide shows how with =SLOPE()), pull it from a data provider, or use an industry average. Published betas are usually levered betas, which already reflect the company’s debt. If the company you’re valuing has a very different debt load, read the guide on levered vs unlevered beta first.

Equity risk premium

The equity risk premium is the input people argue about most, because you can’t observe it directly. Two widely used sources:

• Kroll publishes a recommended US equity risk premium of 5.0%, used with the higher of a 3.5% normalized risk-free rate or the spot 20-year Treasury yield.
• Aswath Damodaran at NYU calculates an implied equity risk premium for the S&P 500 each year. Between 2015 and 2025 it ranged from 4.23% to 6.12%.

A premium somewhere around 5% is a common starting point for US companies. Whatever you choose, note your source so the number can be checked later.

Worked example

Say you’re valuing a listed manufacturer with these inputs:

• Risk-free rate: 5%
• Beta: 1.2
• Equity risk premium: 5%

Step 1. Multiply beta by the equity risk premium: 1.2 x 5% = 6%.

Step 2. Add the risk-free rate: 5% + 6% = 11%.

The cost of equity is 11%. If the company’s shares are expected to return less than 11% a year, investors would rather put their money elsewhere at the same level of risk.

Here’s how the answer changes as beta moves, holding the other two inputs fixed:

Beta	Beta x 5% ERP	Cost of equity
0.8	4.0%	9.0%
1.0	5.0%	10.0%
1.2	6.0%	11.0%
1.5	7.5%	12.5%
2.0	10.0%	15.0%

Each 0.1 change in beta moves the result by half a percentage point when the premium is 5%. That’s why the source of your beta matters so much.

Adding premiums to CAPM

Plain CAPM assumes the company is a large, diversified, listed business in a stable market. When that isn’t true, analysts often add premiums on top:

Ke = Rf + Beta x ERP + Size premium + Country risk premium

A size premium is common for small companies. A country risk premium is added for businesses operating in riskier economies, and Damodaran publishes country risk premiums for most countries. The FAQ on how to add country risk premium to cost of equity covers the different ways to apply it.

For private businesses, the build-up method is often used instead, since there’s no share price to measure beta from.

Where CAPM came from

William Sharpe introduced the model in a 1964 Journal of Finance paper, “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.” He shared the 1990 Nobel Memorial Prize in Economic Sciences with Harry Markowitz and Merton Miller, and CAPM was the work the prize recognized him for.

The idea was simple and new at the time. Investors who hold a diversified portfolio shouldn’t be paid for risk they can diversify away. They should only be paid for the risk the stock adds to the whole market portfolio, and beta measures that.

Limits of CAPM

CAPM is popular because it’s simple and the inputs are easy to find. It has real weaknesses, though.

• Beta is backward-looking. It measures how the stock moved in the past, and the business may have changed since.
• Beta estimates are noisy. Two years of weekly data and five years of monthly data can give different answers for the same stock.
• The equity risk premium is a judgment call. Reasonable sources differ by a percentage point or more.
• One factor may not capture everything. Size, value and other effects have been found in research that CAPM doesn’t explain.
• It needs a traded stock. A private company has no return history to measure.

None of this means you should skip CAPM. It means you should treat the result as an estimate, test a range of inputs, and compare it with other methods like the dividend growth model where they apply.

What to do with the number

Once you have a cost of equity, you can use it on its own to discount cash flows to shareholders, or plug it into the weighted average cost of capital to value the whole business. It also works as a hurdle rate for equity-funded projects.

If you’re wondering whether CAPM and cost of equity are the same thing, they aren’t quite. CAPM is one method for estimating it. The FAQ on whether cost of equity is the same as CAPM explains the difference, and the methodology page lists exactly how the calculator handles each input.