To perform a cash flow-oriented valuation on a company, the implied intrinsic value equals the sum of its future cash flows discounted to their present value (PV) using an appropriate discount rate. the minimum rate of return – corresponding to the risk profile of an investment, which could refer to share issuances by a publicly-traded company or a proposed project that a corporation is under consideration on whether to proceed. The discount rate represents the “hurdle rate” – i.e. Beta (β) of the Underlying Asset (or Security)īefore delving into the core components of the capital asset pricing model (CAPM) theory, we’ll quickly review the discount rate concept under the context of valuation.The CAPM establishes a relationship between the risk and expected return by an investor using three key variables: The capital asset pricing model (CAPM) is a fundamental method in corporate finance used to determine the required rate of return on an investment given its risk profile.

How Does the Capital Asset Pricing Model Work? CAPM calculates the cost of equity (Ke), or expected return, which is a core component of the weighted average cost of capital (WACC).CAPM establishes the relationship between the risk-return profile of a security (or portfolio) based on three variables: the risk-free rate (rf), the beta (β) of the underlying security, and the equity risk premium (ERP).The CAPM formula is: Cost of Equity (Ke) = rf + β (Rm – Rf).The term CAPM stands for “Capital Asset Pricing Model” and is used to measure the cost of equity (ke), or expected rate of return, on a particular security or portfolio.

Capital asset pricing model equation