How to Calculate Expected Return With Beta & Market Risk Premiums

Use a spreadsheet to help calculate a stock’s expected return.

The fair value of a risky stock can be found with the use of the capital asset pricing model, called CAPM for short. The CAPM calculates the stock’s expected return with an equation that shows the relationship between risk and expected market return. The model assumes that the stock’s return must at a minimum be equal to the return of the investment of risk free securities, and that the market operates efficiently. To calculate the expected return with beta and risk market premiums, use the CAPM formula, and include information on the return for U.S. Treasury bills.

Things You'll Need

• Calculator
• Spreadsheet such as Microsoft Excel

Instructions

1. Find the value of the risk free rate of return. This is the return earned by investments in risk free securities, and it normally equals the current yield to maturity of U.S. Treasury bonds. Values for the 10 or 30-year bonds are commonly used.

2. Obtain the value of the stock’s market risk premium. This is the difference between the expected return of an investment minus the risk free rate of return. It tells how much extra the investor may be expected to earn over the original amount of the risk free return. The expected return of an investment is normally the expected return of the market, where the S&P 500 Index is used, and may be found at financial websites such as Yahoo! Finance.

3. Find information on beta, which gives the stock’s sensitivity to changes in the market. It equals one for the stock market and the average company stock. If beta is less than one, the stock is low risk with a low expected return. If beta is greater than one, the stock is high risk, but with an expected return that is higher than the one for the market. This information is also found on financial websites such as MSN Money.

4. Review the CAPM formula. It is r(i) = r(f) + B(E(rm) – r(f)). The variable r(i) is the return on the investment, r(f) is the risk free interest rate, B is beta, and E(rm) is the expected return on the market. The term E(rm) – r(f) is the market risk premium.

5. Apply the formula to a company. Perform the calculations with a calculator or a spreadsheet such as Microsoft Excel. Assume a company has the following values: r(f) = 3.15 percent, Erm = 10 percent, and B = 0.15. Then the rate of return r(i) = 3.15 + 0.15 * (10 – 3.15) = 3.15 + 0.15 * 6.85 = 4.18 percent.

References

• Board of Governors of the Federal Reserve System: Selected Interest Rates
• The Portable MBA in Finance and Accounting; Theodore Grossman et. al.
• Valuing a Business, 5th Edition: The Analysis and Appraisal of Closely Held Companies; Shannon P. Pratt et. al.

Resources

• Business Finance Online; CAPM Calculator: Introduction; Mark A. Lane, Ph.D.
• Mount Holyoke College: Corporate Finance Basics: How Do I Value A Stock?; Alison Hirsch