CAPM Calculator — Cost of Equity (Ke)

CAPM (Capital Asset Pricing Model) estimates the return equity investors require: Cost of Equity Ke = Risk-free Rate + Beta × Equity Risk Premium. With a 4.5% risk-free rate, beta of 1.2 and a 5.5% premium, Ke = 11.1%. Enter your inputs below to compute yours.

The cost of equity is the hardest input in any valuation because, unlike debt, equity carries no stated interest rate — shareholders simply expect to be compensated for the risk they take. CAPM turns that expectation into a concrete number by starting from a risk-free government-bond return and adding a premium scaled to how volatile the business is relative to the market, measured by beta. The result flows directly into WACC as the cost-of-equity component.

Ke = Rf + β × ERP

Worked example (default inputs)

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The formula and the security market line

The capital asset pricing model prices risk in one line: the cost of equity equals the risk-free rate plus beta times the equity risk premium, or Ke = Rf + β × (Rm − Rf). Plot required return against beta and you get the security market line — a straight line rising from the risk-free rate, where every unit of market risk earns a fixed premium. A company with a beta of 1.0 moves with the market and earns the full premium; above 1.0 it is more volatile and investors demand more.

A worked example

With a 4.0% risk-free rate, a beta of 1.20 and a 5.5% equity risk premium, the cost of equity is 4.0% + 1.20 × 5.5% = 10.6%. That figure becomes the equity component of WACC and the discount rate in an equity DCF.

Where each input actually comes from

The risk-free rate is a long-dated government bond yield — a 10-year Treasury for a long-horizon valuation, matched to the life of the cash flows, and sourced from the Federal Reserve's published series. Beta comes from regressing a stock's returns against the market, or for a private company, by taking listed peers' betas, unlevering them to strip out financing risk, averaging for business risk, then relevering at the target's own capital structure. The equity risk premium is the hardest input; practitioners use a historical average, a forward-looking implied premium, or survey data, and the figure genuinely matters — a point on the premium is a point on every cost of equity.

Sources: Federal Reserve H.15 — selected interest rates for the risk-free rate; Damodaran Online for equity risk premium and industry betas.

What the research says — including CAPM's critics

CAPM is the most used model, but it is not unchallenged. Fama and French, in their 2004 review in the Journal of Economic Perspectives, concluded that the model's empirical record is poor enough that its use in applications may not be justified — beta alone explains far less of the variation in returns than the theory predicts, and factors like company size and value (book-to-market) carry independent explanatory power. That research produced the three-factor and later five-factor models. In practice most analysts still use CAPM as the base and layer adjustments on top, because it is transparent and forces every assumption into the open — which is exactly why it remains the standard despite the critique.

Reference: Fama, E. & French, K. (2004), “The Capital Asset Pricing Model: Theory and Evidence”, Journal of Economic Perspectives 18(3).

Case study: relevering beta for a private valuation

A private payments company has no traded shares, so it has no beta of its own. The analyst takes three listed peers with levered betas of 1.30, 1.10 and 1.45 and debt-to-equity ratios of 0.50, 0.25 and 0.80. Unlevering each — dividing by [1 + (1 − 0.25) × D/E] — collapses them to asset betas clustered near 0.93, the shared business risk once financing is removed. Relevering that 0.93 at the target's own 0.40 debt-to-equity gives a beta of about 1.20. Feeding the raw peer average of 1.28 instead would have overstated the cost of equity by nearly a point, and the valuation with it. The unlever-relever step is not optional finesse; it is the difference between a defensible discount rate and a wrong one.

The size premium debate

Small companies have historically returned more than their betas alone predict — the size effect first documented by Banz in 1981. Valuers commonly add a size premium of a few percentage points on top of the CAPM cost of equity for small private businesses, a practice codified in the widely licensed Kroll (formerly Duff & Phelps) Cost of Capital data. The premium is contested — some researchers argue it has weakened or reflects liquidity rather than size — so treat it as a defensible adjustment to disclose, not an automatic add-on.

Matching the risk-free rate to the horizon

One quiet error deserves its own mention: the maturity of the risk-free rate should match the horizon of the cash flows. Valuing a business whose value stretches decades into the future against a three-month Treasury bill introduces a mismatch that a 10- or 20-year government bond avoids. The bond yield already embeds the market's long-run inflation and rate expectations, which is exactly what a long-horizon discount rate needs. It is a small choice that quietly shifts every cost of equity, and getting it right costs nothing.

Beyond CAPM: the build-up method

For a small private company, many valuers extend CAPM into a build-up model that adds the risks CAPM's single beta cannot capture. The stack starts at the risk-free rate, adds the equity risk premium (often scaled by an industry risk factor), then adds a size premium, and finally a company-specific premium for concentration, key-person dependence or thin financials. The logic is the same as CAPM — compensate investors for each layer of risk they bear — but it makes the small-company premiums explicit rather than hiding them inside a borrowed beta. The result is usually a higher, and more honest, cost of equity than a naive CAPM would produce for a business that a diversified public-market beta was never designed to describe.

From cost of equity to a valuation

CAPM produces one number: the return equity investors require. On its own it values nothing. Blended with the after-tax cost of debt it becomes WACC; applied to equity cash flows it discounts an equity DCF. The generated model builds the whole chain — CAPM cost of equity, WACC, and the DCF it feeds — as live Excel formulas, so a change to beta or the premium flows straight through to enterprise value. Free for a 3-year model.

Frequently asked questions

What beta should I use?

Use the average beta of listed companies in your sector, releveraged for your capital structure. Stable utilities run ~0.5–0.8; typical operating businesses ~1.0–1.3; early-stage or cyclical businesses 1.5+.

What is the equity risk premium?

The extra return investors demand for holding equities over government bonds — commonly estimated at 4.5–6% for developed markets, higher for emerging markets.

How does CAPM feed into WACC?

CAPM produces the cost of equity, which is blended with the after-tax cost of debt by capital-structure weights to give WACC — the discount rate used in DCF.

Can beta be negative?

Very rarely. A negative beta means an asset moves opposite to the market (gold is sometimes cited). For almost all operating businesses beta is positive, typically between 0.5 and 2.0.

What equity risk premium should I use?

For developed markets, a premium of roughly 4.5–6% is the common working range, whether taken from long-run historical averages or forward-looking implied estimates. Emerging markets carry more. Because the figure moves every cost of equity one-for-one, state your source and be consistent across the whole valuation.

Can beta be greater than 2 or negative?

Both are possible but rare for operating businesses. High-beta names (above 1.5) are volatile or cyclical; a negative beta implies an asset that moves opposite to the market, which almost no operating company does. Most businesses sit between 0.5 and 1.6.

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