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L.1 · ADVANCED · 2 MIN

Cost of Equity: Beyond Textbook CAPM

CAPM gives you Cost of Equity = Rf + β × ERP, but professionals know it’s a starting point, not the answer. Three problems undermine naive CAPM that you must address for credible valuations.

Quiz · 5 questions ↓
§ 01
AAPL — Debt/Equity, Market Cap. Open AAPL on the Ledge to see current values.
§ 02
CAPM ProblemIssueProfessional Fix
Unstable betaBeta changes with time period and market conditionsUse 2–5 year weekly returns; compare to industry median
Risk-free rate debate10-year or 30-year Treasury? Current or normalized?Match to investment horizon; current for near-term, normalized for terminal value
ERP estimationHistorical premium (5–7%) vs. implied forward (~4–5%)Use Damodaran’s implied ERP, updated annually
§ 03

Beyond CAPM, three alternative models capture risk CAPM misses: Fama-French (adds size and value factors), Build-up Method (adds company-specific risk premia), and the Implied Cost of Capital from current market prices. Note: these are practitioner adjustments, not extensions of CAPM theory. Strict CAPM only prices systematic risk via beta - adding idiosyncratic premia violates CAPM's diversifiability assumption. The size premium in particular has weakened or disappeared in some post-1980 datasets (Banz 1981 found it; Fama-French 1992 confirmed it; more recent SPIVA/AQR studies show it small or insignificant). Treat build-up adjustments as defensible practitioner judgment, not theoretical law.

§ 04
Look up a stock’s beta in **Fundamentals**. Is it stable over 1, 3, and 5 years? If not, consider using the industry average beta instead of the company-specific one.
§ 05
A stock’s 2-year beta is 1.4 but its 5-year beta is 0.9 and the industry average is 1.1. Which beta should you use?
§ 06

The Equity Risk Premium is the most impactful and debatable number in finance. A 1% change in ERP changes every stock valuation on earth. Use implied (forward-looking) ERP when available, not historical averages.

Five questions · AI feedback

Sit with the ideas.

You are valuing a $500M market cap specialty chemical company. CAPM gives 11% cost of equity (4.5% Rf + 1.3 beta x 5% ERP). The company has one customer representing 35% of revenue and its CEO founded the business with no clear successor. How should you adjust?

Why:

Other lessons in this course.

  1. 01Cost of Equity: Beyond Textbook CAPM— reading now
  2. 02Cost of Debt: What Lenders Actually Charge
  3. 03How Leverage Changes Everything: The Modigliani-Miller Framework
  4. 04Unlevering and Relevering Beta
  5. 05Capital Structure Optimization: Finding the Sweet Spot
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