The CAPM estimate of rs is equal to the risk-free rate, rRF, plus a risk premium that is equal to the risk premium on an average stock, (rM - rRF), scaled up or down to reflect the particular stock's risk as measured by its beta coefficient, bi.
This model assumes that a firm's stockholders are well diversified, but if they are not well diversified, then the firm's true investment risk would not be measured by beta - and the CAPM estimate would understate the correct value of rs.
How does CAPM work ?
The Capital Asset Pricing Model (CAPM) estimates the expected return on a stock (rs) as the sum of two components: the risk-free rate (rRF) and a risk premium. The risk premium is determined by the difference between the expected return of the overall market (rM) and the risk-free rate.
However, an important assumption in the CAPM is that stockholders are well-diversified, meaning they have a portfolio of various investments. If stockholders are not well-diversified and have a significant portion of their wealth tied up in a single stock, then the CAPM estimate may not accurately reflect the stock's true investment risk.
In such cases, the stock's beta may not adequately capture its risk, and the CAPM estimate of rs would underestimate the correct value of the required return.