Capital Asset Pricing Model (CAPM)

How investors translate risk into expected return

Update: Dec 13, 2025 Siert Bruins

With the Capital Asset Pricing Model (CAPM), an investor determines how much return is required as compensation for taking risk. I already briefly introduced CAPM on the previous page about the DCF method, because this model plays a crucial supporting role in valuation. CAPM is not a valuation method by itself. Instead, it is an investment theory that helps you think about the return you should reasonably expect when you invest in a startup, an invention, or any other uncertain project.

The core idea and the basic law in finance is simple: money invested in a risky venture should earn more than money safely parked in a bank account. According to CAPM, this so-called required return consists of two components: a risk-free return and an additional risk premium that reflects the uncertainty of the project or company. Together, these determine the discount rate that investors later use in valuation models such as DCF. The required return can be calculated using the following formula:

Let's look at the parameters in this formula.

1. r _i is the discount rate or required return: the required rate of return.
2. R _f is the risk-free rate. For the risk-free rate, the interest on government bonds is taken if you are valuing a Dutch project or the so-called American T-bill if a project is valued in the US. You should determine for yourself which government bonds are suitable for use in your own country.The term "risk-free" is used because the government, which issues these bonds, is always expected to be able to pay the interest and principal. However, nowadays, given the developments in Greece and Ireland during the financial crisis, this is sometimes viewed with more nuance. The specific interest rate you should use, whether it's the 3-month rate, 1-year, 5-year, or longer, depends on the duration of the project.
3. R _m is the return on the (market) portfolio. The return is not always known and sometimes difficult to determine. Instead, attention is paid to the quantity (Rm - Rf), also called the risk premium. It turns out that this has averaged about 7% over time, and we will use this from now on.
4. β_i is the sensitivity or risk associated with a specific company, project, etc. β_i is the sensitivity or risk associated with the expected return of investment i, and differs for each company or investment. If β_i > 1, it means that the investment exhibits higher sensitivity (greater fluctuations in value) compared to the market when β_i < 1. For an extensive discussion of this topic , we refer you to two books: The first is Brealey & Myers: Principles of Corporate Finance, as well as Andrew Metrick: Venture Capital and the Finance of Innovation.

The Applied Capital Asset Pricing Model

Let's take a moment to reflect on what we have so far. At the time of writing, the 5-year interest rate on a USA government bond is assumed to be 2.4%. According to the Capital Asset Pricing Model, the discount rate, ri, for a project, i, would be:

r_i = 0.024 + β_i * 0.07

In case we invest in a project with the same risk profile as the market, i.e. β_i, this would be:

r_i = 0.024 + 0.07 = 9.4%

According to the Capital Asset Pricing Model, it is important to know what the β for a project is. For existing companies, this is relatively easy because their cost of capital is known. However, inventors face a problem because they don't have a company history, cannot determine β, and therefore, don't have a cost of capital. Fortunately, experience and knowledge about the cost of capital of similar industries provide insights. No matter how new and spectacular your invention may be, it can always be categorized into a certain industry or sector that has existed for a longer time, and for which data are available.

The table below shows a few cost of capital values (discount rates) for different sectors. As you can see, the values vary greatly, from 5.83% for the soft drinks industry to as much as 18.14% for E-commerce.

Type of Industry and Cost of Capital (r)

• Advertising: 9.03%
• Auto Parts: 7.69%
• Beverage (alcoholic): 6.43%
• Beverage (soft drink): 5.83%
• Biotechnology: 10.28%
• Computer Software/Services: 13.13%
• Computers and Peripheral Equipment: 13.43%
• Drug: 10.05%
• E-commerce: 18.14%
• Electrical Equipment: 8.27%
• Electronics: 10.24%
• Entertainment: 9.58%
• Entertainment: Tech 12.78%
• Environmental: 6.31%
• Healthcare Information: 8.67%
• Home Appliance: 7.12%
• Household Products: 7.27%
• Information Services: 8.30%
• Internet: 16.56%
• Medical Services: 7.57%
• Medical Supplies: 8.09%
• Office Equipment/Supplies: 7.52%
• Pharmacy Services: 7.66%
• Semiconductor: 16.24%
• Telecom. Equipment: 14.82%
• Wireless Networking: 13.58%

Using the table above and the earlier data, we can now answer the practical question that keeps coming back: is it better—according to the Capital Asset Pricing Model—to put your money safely in the bank, or to invest it in a risky biotechnology company? In the latter case, you cannot avoid performing a valuation of the company.

On the next page, I will do exactly that by using a spreadsheet to calculate the Net Present Value (NPV). But before we move on, there is one important question to address. Many people wonder what the purpose of such a CAPM table is if inputs like the risk profile (β) or the risk-free rate (Rf) can change on a daily basis.

That concern is valid. In practice, however, it is reasonable to work with average values for the cost of capital. Over longer periods, these variables tend to fluctuate around a mean. Still, this does not mean you can blindly reuse old numbers: risk profiles of both investors and companies change over time, and so should the assumptions in your valuation.