Maybe this obvious and I'm an idiot, but I'm interested in what hearing a few answers to this question.
CAPM says that the cost of equity (Ke) is equal to the risk free rate(Rf) plus beta (b) times the market return premium (Rm-Re).
Ke=Rf+b(Rm-Re)
My question is, how is it possible to trust CAPM in the context of a DCF in a year like 2011 when the Market Return Premium is around zero (potentially negative) given that the risk free rate of 10 year treasuries is greater than the annual return on any of the major indexes? Do you use a different source for Rm (i.e. using the return on a blended asset portfolio that invests in bonds/commodities/stocks rather than comparing to equity market growth)?
Certainly one answer might be that the value of companies changes relative to the return on the equity markets for that year and in a down year like 2011 the DCF is still accurate and simply reflects the low equity returns of that year. Maybe this is just one of the major pitfalls of using CAPM to determine the cost of equity (and potentially the DCF valuation model as a whole)--I'm interested to hear some responses.
You would want the expected, forward looking return on the market, not the realized return of the last few year(s). Google how to estimate it, though this is generally not that easy. Alternatively, look it up in Ibbotson or similar book - they make a living by estimating stuff like this. Or just use 6% for (Rm - Rf) and call it a day.
Also, to answer your 2nd question, you would always only want to look at equity markets.
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