CAPM and the Cost of Equity

Introduction

The cost of equity is the return that equity investors require to compensate them for the risk of owning the company's stock. It is the most important component of WACC for most companies (since equity typically represents a larger portion of the capital structure than debt) and directly determines the discount rate in the DCF model.

The Capital Asset Pricing Model (CAPM) is the standard framework for estimating the cost of equity in investment banking. While CAPM has well-known theoretical limitations, it remains the dominant model because it is intuitive, transparent, and produces inputs that can be sourced from observable market data.

Each component requires a specific input, and the choices the analyst makes for each one affect the final cost of equity and, through WACC, the entire DCF output.

The risk-free rate represents the return on a theoretically riskless investment. In practice, the yield on a 10-year US Treasury bond is the standard proxy for US dollar-denominated valuations. The 10-year maturity is used because it approximates the duration of the cash flows in a typical DCF (5-10 year projection period plus terminal value).

As of early 2026, the 10-year Treasury yield is approximately 4.2-4.5%, significantly higher than the 1.5-2.0% range that prevailed in 2020-2021. This increase has a direct impact on valuations: a higher risk-free rate increases the cost of equity, increases WACC, and reduces the present value of future cash flows in every DCF model.

Beta measures the systematic risk of the stock: how much the stock's returns move relative to the broader market. A beta of 1.0 means the stock moves in line with the market. A beta above 1.0 means it is more volatile (and riskier) than the market. A beta below 1.0 means it is less volatile.

In the CAPM formula, beta scales the equity risk premium to reflect the specific company's risk. A high-beta company (beta of 1.5, typical of a cyclical industrial or a high-growth technology company) has a higher cost of equity than a low-beta company (beta of 0.6, typical of a utility or consumer staple), reflecting the higher risk that equity investors bear.

Where to Source Beta

Beta (CAPM)

A measure of a stock's sensitivity to systematic (market-wide) risk. A beta of 1.0 indicates that the stock moves in line with the market. A beta of 1.3 means the stock is 30% more volatile than the market on average, while a beta of 0.7 means it is 30% less volatile. In the CAPM, beta scales the equity risk premium to reflect the specific company's risk level. Beta captures only systematic risk (risk that cannot be diversified away), not company-specific risk, which CAPM assumes investors have eliminated through portfolio diversification.

The equity risk premium is the incremental return that investors demand for holding the market portfolio of equities over the risk-free rate. It represents the compensation for bearing the systematic risk of the equity market as a whole.

Equity Risk Premium (ERP)

The additional return that investors demand for holding equities (risky assets) over risk-free government bonds. The ERP is the most debated input in the CAPM because it is not directly observable and different estimation methods produce materially different values. Historical approaches (measuring past equity returns above Treasury returns) yield 5-7%. Forward-looking (implied) approaches, which back out the premium from current stock prices and expected growth, typically yield 4-6%. The choice of ERP has a significant impact on every DCF: for a company with a beta of 1.2, a 1% change in ERP shifts the cost of equity by 1.2 percentage points, which can move the implied enterprise value by 10% or more.

The ERP is not directly observable and must be estimated. The two main approaches:

Most investment banks use an ERP in the 5-7% range, with the specific figure varying by bank and by the valuation context. Some banks have a standardized house view on ERP that is used consistently across all models to ensure comparability across engagements. Others allow deal teams to select an ERP within an approved range based on the specific market environment. The ERP selected has a meaningful impact on the final valuation: a 1% change in ERP (e.g., from 5.5% to 6.5%) shifts the cost of equity by the company's beta (if beta is 1.2, the cost of equity moves by 1.2%), which flows through WACC and affects the entire DCF output.

For emerging market valuations, the ERP is typically higher to reflect greater political, currency, and liquidity risk. A common approach is to start with the US ERP and add a country risk premium based on sovereign credit default swap spreads or sovereign bond yield spreads.

For a mid-cap industrial company with an adjusted beta of 1.1:

This 10.35% cost of equity becomes the equity component of the WACC calculation.