The Capital Asset Pricing Model (CAPM) isn't just a formula—it's a framework that connects market expectations to investor behavior. When we use CAPM to calculate the cost of equity, we're trying to quantify the return an investor demands for taking on risk. But to use this model well, it's important to go beyond the equation and understand how each input really works.

The risk-free rate serves as the foundation. It's usually based on the yield of long-term government bonds and represents the return an investor would accept if they wanted zero risk. While it's often treated as stable, it's actually sensitive to inflation expectations and macroeconomic policy. When rates rise, so does the baseline return required from any risky investment.

The beta ($b$) coefficient brings volatility into the picture. It's a measure of how much a stock's returns move in relation to the broader market. A beta greater than 1 means the stock amplifies market movements—rising more during upswings and falling more during downturns. A lower beta indicates less sensitivity. But beta is backward-looking, based on historical data, so it may not always capture future realities, especially for high-growth or rapidly evolving companies.

Finally, the market risk premium reflects the additional return investors expect from equities over risk-free assets. It captures how much "reward" the market demands for "risk". In strong economic periods, this spread may be modest. In times of uncertainty or crisis, investors want more compensation—so the premium widens.

Together, these three components allow us to estimate the return required by equity investors. But it's important to remember: CAPM assumes efficient markets and rational investors. In real-world finance, other risks—like company-specific issues or geopolitical shocks—might also influence required returns, even if they're not built into the formula.

This foundation will become essential as you apply CAPM in live valuations. The better you understand the parts, the better your judgment in choosing the right values—and that's where real-world finance begins.