Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model, or CAPM, calculates the return that equity investors may expect for their risk. It consists of the risk-free rate, market risk, and the beta of the respective stock. In company valuation, the model is used to determine the cost of equity.

The formula is: expected return equals the risk-free rate plus beta multiplied by the market risk premium, where the market risk premium is the difference between the expected return of the overall market and the risk-free rate. The underlying idea is that only systematic risk is rewarded, because company-specific risk disappears through diversification. In Germany the model is effectively the standard through IDW valuation practice: the base rate is derived from the Bundesbank yield curve, the valuation committee publishes regularly updated ranges for the market risk premium, and beta is taken from a group of listed comparables.

For unlisted companies, premiums are added in practice for small size, illiquidity of the shares or country risk, which strictly speaking goes beyond the model and should therefore be disclosed and explained. The model's limits are well known: it assumes efficient markets, homogeneous expectations and a single risk factor, and empirical work shows that beta alone explains observed return differences only in part, which is why extensions with factors such as size or valuation level were developed. In transaction practice CAPM nevertheless remains the usual basis, because it is transparent, auditable and accepted in expert reports.

The result is the cost of equity, which together with the cost of debt and the target capital structure feeds into the weighted average cost of capital. Applying the model to small unlisted companies deserves scrutiny, because it was developed for a broadly diversified portfolio investor, while the typical owner of a mid-sized company is precisely not diversified and therefore also bears company-specific risk. That explains the practice of adding premiums the model itself does not provide for. Anyone applying them should justify and disclose their level, since otherwise they become a freely adjustable figure.