CAPM and the cost of equity
By SuperdayReps · Wharton MBA · ex-Greenhill · investment banking interview coaching
6 min read · updated July 2, 2026
The cost of equity answers one question: what return do shareholders demand for putting their money in this stock instead of something safer? It's a required return, not a promise. And you need it because it's the single biggest input into WACC, which is the discount rate in your DCF. Get the cost of equity wrong and the whole valuation moves.
The market's standard tool for estimating it is the Capital Asset Pricing Model, or CAPM. It's not perfect. Academics have poked holes in it for decades. But it's what banks use, so it's what you need to know cold.
The formula
Three inputs, that's the whole thing. Read it left to right and it tells a story: start with what you'd earn risk-free, then add extra return for taking on risk, scaled to how risky this particular stock is.
| Input | What it is | Rough range |
|---|---|---|
| (risk-free rate) | Yield on a long-dated government bond, usually the 10-year Treasury | 3% to 5% |
| (beta) | How much the stock moves relative to the market | 0.5 to 2.0 |
| (equity risk premium) | Extra return investors demand for holding stocks over bonds | 5% to 7% |
The term is the equity risk premium, the reward for holding the whole stock market instead of a safe bond. Beta then dials that premium up or down for the specific company.
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Frequently asked
- What is the cost of equity?
- The cost of equity is the return shareholders demand for putting their money in a stock instead of something safer. It is a required return, not a promise, and it is the single biggest input into WACC, which is the discount rate in a DCF. Get it wrong and the whole valuation moves.
- What is the CAPM formula for cost of equity?
- CAPM says cost of equity equals the risk-free rate plus beta times the equity risk premium. You start with what you would earn risk-free, usually the 10-year Treasury, then add extra return for taking on risk, scaled by beta to reflect how risky that particular stock is versus the market.
- Is the cost of equity the same as WACC?
- No. CAPM gives you the return equity holders demand, which is only one input to WACC. WACC blends that cost of equity with the after-tax cost of debt, weighted by capital structure. Never discount unlevered free cash flow at the cost of equity alone. Say cost of equity for CAPM's output and WACC for the blended rate.
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