How to estimate the price of a stock using CAPM

The CAPM

The Capital Asset Pricing Model gives the return investors should require from a stock, based on its market risk:

E(r) = r_f + β × [E(r_m) − r_f]

• r_f: the risk-free rate, such as the Treasury bill yield
• β (beta): how much the stock moves with the market (see how to measure it in Excel)
• E(r_m) − r_f: the market risk premium, the extra return the market is expected to earn over the risk-free rate

Step 1: the required return

• Risk-free rate: 4%
• Beta: 1.2
• Market risk premium: 6%

E(r) = 4% + 1.2 × 6% = 11.2%

Step 2: the stock price

Use the required return as the discount rate in the constant-growth dividend discount model:

P₀ = D₁ ÷ (k − g)

• Next year’s dividend D₁: $2.00
• Dividend growth g: 5%

P₀ = 2.00 ÷ (0.112 − 0.05) = $32.26

Interpreting the result

• If the stock trades below $32.26, the model says it’s undervalued: its expected return is higher than 11.2%.
• If it trades above, it may be overvalued.

Keep in mind

• Beta, the risk premium and the growth rate are all estimates, and the price is sensitive to each.
• The CAPM only rewards market risk: risk that can be diversified away earns no extra return.

This lesson is for education only and isn’t investment advice.

Next chapter: how to calculate a bond price.