ERk = rf + Bk (ERp - rf) where:
ERk is the expected return on the stock for the yearERk = .06 + Bk (ERp -.06)
rf is the risk free rate of return
Bk is the beta of stock k
ERp is the expected return on the market portfolio (typically the S&P500)
While this may seem extremely complicated at first glance, it really isn't at all. In fact, Bk is the only real variable. The risk free rate of return, using the sensible assumption that the United States government won't default, is simply the return on a 30-year T-bond, which is typically around 6%. The expected return on the market portfolio can be estimated using the fact that the market has averaged a 12% return historically, or it can be estimated using analysts' estimates for the coming year. Thus, the equation simply becomes:
Using the Expected Return
After you have calculated the expected return of the stock in question, it is very simple to make some conclusions as to whether or not you should invest in that stock. For example, if ERk < ERp, you may not want to invest in the stock because even if it will make you money, stock k will have a lower return than the market, and therefore, the money could be better invested elsewhere. On the other hand, investors should remember that a high expected return also implies a high risk of a negative so investors shouldn't rush into an investment based solely on the CAPM. Either way, it gives you a starting point in valuing the stock, and as Oscar Wilde stated in Lady Windermere's Fan, a cynic is "a man who knows the price of everything and the value of nothing."