Stock Investing 101 – Required Rate of Return

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Required Rate of Return – RRR

What Is Required Rate of Return – RRR?

The required rate of return is the minimum return an investor will accept for owning a company’s stock, as compensation for a given level of risk associated with holding the stock. The RRR is also used in corporate finance to analyze the profitability of potential investment projects.

The required rate of return is also known as the hurdle rate, which like RRR, denotes the appropriate compensation needed for the level of risk present. Riskier projects usually have higher hurdle rates or RRRs than those that are less risky.

Required Rate Of Return

The Formula and Calculating RRR

There are a couple of ways to calculate the required rate of return. If an investor is considering buying equity shares in a company that pays dividends, the dividend-discount model is ideal. The dividend discount model is also known as the Gordon growth model.

The dividend-discount model calculates the RRR for equity of a dividend-paying stock by utilizing the current stock price, the dividend payment per share, and the forecasted dividend growth rate. The formula is as follows:

Calculating RRR Using the Dividend-Discount Model.

  1. Take the expected dividend payment and divide it by the current stock price.
  2. Add the result to the forecasted dividend growth rate.

How to Calculate Required Rate of Return

Another way to calculate RRR is to use the capital asset pricing model (CAPM), which is typically used by investors for stocks that don’t pay dividends.

The CAPM model of calculating RRR uses the beta of an asset. Beta is the risk coefficient of the holding. In other words, beta attempts to measure the riskiness of a stock or investment over time. Stocks with betas greater than 1 are considered riskier than the overall market (represented by the S&P 500), whereas stocks with betas less than 1 are considered less risky than the overall market.

The formula also uses the risk-free rate of return, which is typically the yield on short-term U.S. Treasury securities. The final variable is the market rate of return, which is typically the annual return of the S&P 500 index. The formula for RRR using the CAPM model is as follows:

Calculating RRR using CAPM

  1. Add the current risk-free rate of return to the beta of the security.
  2. Take the market rate of return and subtract the risk-free rate of return.
  3. Add the results to achieve the required rate of return.

Subtract the risk-free rate of return from the market rate of return.

Take that result and multiply it by the beta of the security.

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Add the result to the current risk-free rate of return to determine the required rate of return.

Key Takeaways

  • The required rate of return is the minimum return an investor will accept for owning a company’s stock, that compensates them for a given level of risk.
  • Inflation must also be factored into an RRR calculation, which finds the minimum rate of return an investor considers acceptable, taking into account their cost of capital, inflation and the return available on other investments.
  • The RRR is a subjective minimum rate of return, and a retiree will have a lower risk tolerance and therefore accept a smaller return than an investor who recently graduated college.

What Does RRR Tell You?

The required rate of return RRR is a key concept in equity valuation and corporate finance. It’s a difficult metric to pinpoint due to the different investment goals and risk tolerance of individual investors and companies. Risk-return preferences, inflation expectations, and a company’s capital structure all play a role in determining the company’s own required rate. Each one of these and other factors can have major effects on a security’s intrinsic value.

For investors using the CAPM formula, the required rate of return for a stock with a high beta relative to the market should have a higher RRR. The higher RRR relative to other investments with low betas is necessary to compensate investors for the added level of risk associated with investing in the higher beta stock.

In other words, RRR is in part calculated by adding the risk premium to the expected risk-free rate of return to account for the added volatility and subsequent risk.

For capital projects, RRR is useful in determining whether to pursue one project versus another. The RRR is what’s needed to go ahead with the project although some projects might not meet the RRR but are in the long-term best interests of the company.

Inflation must also be factored into RRR analysis. The RRR on a stock is the minimum rate of return on a stock that an investor considers acceptable, taking into account their cost of capital, inflation and the return available on other investments.

For example, if inflation is 3% per year, and the equity risk premium over the risk-free return (using a U.S. Treasury bill which returns 3%), then an investor might require a return of 9% per year to make the stock investment worthwhile. This is because a 9% return is really a 6% return after inflation, which means the investor would not be rewarded for the risk they were taking. They would receive the same risk-adjusted return by investing in the 3% yielding Treasury bill, which would have a zero real rate of return after adjusting for inflation.

Examples of RRR

A company is expected to pay an annual dividend of $3 next year, and its stock is currently trading at $100 a share. The company has been steadily raising its dividend each year at a 4% growth rate.

  • RRR = 7% or (($3 expected dividend / $100 per share) + 0.04 growth rate)

In the capital asset pricing model (CAPM), RRR can be calculated using the beta of a security, or risk coefficient, as well as the excess return that investing in the stock pays over a risk-free rate, is the equity risk premium.

RRR Using CAPM Formula Example

  • A company has a beta of 1.50 meaning it’s riskier than the overall market’s beta of one.
  • The current risk-free rate is 2% on a short-term U.S. Treasury.
  • The long-term average rate of return for the market is 10%.
  • RRR = 12% or (0.02 + 1.50 x (0.10 – 0.02)).

RRR vs. Cost of Capital

Although the required rate of return is used in capital budgeting projects, RRR is not the same level of return that’s needed to cover the cost of capital. The cost of capital is the minimum return needed to cover the cost of debt and issuing equity to raise funds for the project. The cost of capital is the lowest return needed to account for the capital structure. The RRR should always be higher than the cost of capital.

Limitations of RRR

The RRR calculation does not factor in inflation expectations since rising prices erode investment gains. However, inflation expectations are subjective and can be wrong.

Also, the RRR will vary between investors with different risk tolerance levels. A retiree will have a lower risk tolerance than an investor who recently graduated college. As a result, the RRR is a subjective rate of return.

RRR does not factor in the liquidity of an investment. If an investment can’t be sold for a period of time, the security will likely carry a higher risk than one that’s more liquid.

Also, comparing stocks in different industries can be difficult since the risk or beta will be different. As with any financial ratio or metric, it’s best to utilize multiple ratios in your analysis when considering investment opportunities.

Calculating Required Rate of Return – RRR

What Is Required Rate of Return – RRR?

The required rate of return (RRR) is the minimum amount of profit (return) an investor will receive for assuming the risk of investing in a stock or another type of security. RRR also can be used to calculate how profitable a project might be relative to the cost of funding the project. RRR signals the level of risk that’s involved in committing to a given investment or project. The greater the return, the greater the level of risk. A lesser return generally means that there is less risk. RRR is commonly used in corporate finance and when valuing equities (stocks). You may use RRR to calculate your potential return on investment (ROI).

When looking at an RRR, it is important to remember that it does not factor in inflation. Also, keep in mind that the required rate of return can vary among investors depending on their tolerance for risk.

Required Rate Of Return

What RRR Considers

To calculate the required rate of return, you must look at factors such as the return of the market as a whole, the rate you could get if you took on no risk (risk-free rate of return), and the volatility of a stock (or overall cost of funding a project).

The required rate of return is a difficult metric to pinpoint because individuals who perform the analysis will have different estimates and preferences. The risk-return preferences, inflation expectations, and a firm’s capital structure all play a role in determining the required rate. Each of these, among other factors, can have major effects on an asset’s intrinsic value. As with many things, practice makes perfect. As you refine your preferences and dial in estimates, your investment decisions will become dramatically more predictable.

Discounting Models

One important use of the required rate of return is in discounting most types of cash flow models and some relative-value techniques. Discounting different types of the cash flow will use slightly different rates with the same intention—to find the net present value (NPV).

Common uses of the required rate of return include:

  • Calculating the present value of dividend income for the purpose of evaluating stock prices
  • Calculating the present value of free cash flow to equity
  • Calculating the present value of operating free cash flow

Analysts make equity, debt, and corporate expansion decisions by placing a value on the periodic cash received and measuring it against the cash paid. The goal is to receive more than you paid. Corporate finance focuses on how much profit you make (the return) compared to how much you paid to fund a project. Equity investing focuses on the return compared to the amount of risk you took in making the investment.

Equity and Debt

Equity investing uses the required rate of return in various calculations. For example, the dividend discount model uses the RRR to discount the periodic payments and calculate the value of the stock. You may find the required rate of return by using the capital asset pricing model (CAPM).

The CAPM requires that you find certain inputs including:

  • The risk-free rate (RFR)
  • The stock’s beta
  • The expected market return

Start with an estimate of the risk-free rate. You could use the yield to maturity (YTM) of a 10-year Treasury bill—let’s say it’s 4%. Next, take the expected market risk premium for the stock, which can have a wide range of estimates.

For example, it could range between 3% and 9%, based on factors such as business risk, liquidity risk, and financial risk. Or, you can derive it from historical yearly market returns. For illustrative purposes, we’ll use 6% rather than any of the extreme values. Often, the market return will be estimated by a brokerage firm, and you can subtract the risk-free rate.

Or, you can use the beta of the stock. The beta for a stock can be found on most investment websites.

To calculate beta manually, use the following regression model:

βstock is the beta coefficient for the stock. This means it is the covariance between the stock and the market, divided by the variance of the market. We will assume that the beta is 1.25.

Rmarket is the return expected from the market. For example, the return of the S&P 500 can be used for all stocks that trade, and even some stocks not on the index, but related to businesses that are.

Now, we put together these three numbers using the CAPM:

Dividend Discount Approach

Another approach is the dividend-discount model, also known as the Gordon growth model (GGM). This model determines a stock’s intrinsic value based on dividend growth at a constant rate. By finding the current stock price, the dividend payment, and an estimate of the growth rate for dividends, you can rearrange the formula into:

Importantly, there need to be some assumptions, in particular the continued growth of the dividend at a constant rate. So, this calculation only works with companies that have stable dividend-per-share growth rates.

RRR in Corporate Finance

Investment decisions are not limited to stocks. In corporate finance, whenever a company invests in an expansion or marketing campaign, an analyst can look at the minimum return these expenditures demand relative to the degree of risk the firm expended. If a current project provides a lower return than other potential projects, the project will not go forward. Many factors—including risk, time frame, and available resources—go into deciding whether to forge ahead with a project. Typically though, the required rate of return is the pivotal factor when deciding between multiple investments.

In corporate finance, when looking at an investment decision, the overall required rate of return will be the weighted average cost of capital (WACC).

Capital Structure

Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the cost of financing new projects based on how a company is structured. If a company is 100% debt financed, then you would use the interest on the issued debt and adjust for taxes—as interest is tax deductible—to determine the cost. In reality, a corporation is much more complex.

The True Cost of Capital

Finding the true cost of capital requires a calculation based on a number of sources. Some would even argue that, under certain assumptions, the capital structure is irrelevant, as outlined in the Modigliani-Miller theorem. According to this theory, a firm’s market value is calculated using its earning power and the risk of its underlying assets. It also assumes that the firm is separate from the way it finances investments or distributes dividends.

To calculate WACC, take the weight of the financing source and multiply it by the corresponding cost. However, there is one exception: Multiply the debt portion by one minus the tax rate, then add the totals. The equation is:

When dealing with corporate decisions to expand or take on new projects, the required rate of return is used as a benchmark of minimum acceptable return, given the cost and returns of other available investment opportunities.

What Is a Good Return on Your Investments?

Reasonable Return Expectations Can Help Avoid Too Much Risk

One of the main reasons new investors lose money is because they chase after unrealistic rates of return on their investments, whether they are buying stocks, bonds, mutual funds, real estate, or some other asset class. Most folks don’t understand how compounding works. Every percentage increase in profit each year could mean huge increases in your ultimate wealth over time. To provide a stark illustration, $10,000 invested at 10% for 100 years turns into $137.8 million. The same $10,000 invested at twice the rate of return, 20%, does not merely double the outcome; it turns it into $828.2 billion. It seems counter-intuitive that the difference between a 10% return and a 20% return is 6,010x as much money, but it’s the nature of geometric growth. Another example is illustrated in the chart below.

What Is a Good Rate of Return?

The first thing we need to do is strip out inflation. The reality is, investors are interested in increasing their purchasing power. That is, they don’t care about “dollars” or “yen” per se, they care about how many cheeseburgers, cars, pianos, computers, or pairs of shoes they can purchase.

When we do that and look through the data, we see the rate of return varies by asset types:

Typically gold hasn’t appreciated in real terms over long periods of time. Instead, it is merely a store of value that maintains its purchasing power.   Decade by decade, though, gold can be highly volatile, going from huge highs to depressing lows in a matter of years, making it far from a safe place to store money you may need in the next few years. 

Fiat currencies can depreciate in value over time.   Burying cash in coffee cans in your yard is a terrible long-term investing plan. If it manages to survive the elements, it will still be worthless given enough time.

Bonds

From 1926 through 2020, the average annual return for bonds has been 5.3.%.   The riskier the bond, the higher the return investors demand. 

Business Ownership, Including Stocks

Looking at what people expect from their business ownership, it is amazing how consistent human nature can be. Also, since 1926, the average annual return for stocks has been 10.1%. 

The riskier the business, the higher the return demanded.   It explains why someone might demand a shot at double- or triple-digit returns on a startup due to the fact the risk of failure and even total wipe-out are much higher.

Real Estate

Without using any debt, real estate return demands from investors mirror those of business ownership and stocks. We have gone through decades of about 3% inflation over the past 30 years. 

Riskier projects require higher rates of return. Plus, real estate investors are known for using mortgages, which are a form of leverage, to increase the return on their investment.   The present low-interest-rate environment has resulted in some significant deviations in recent years, with investors accepting cap rates that are substantially below what many long-term investors might consider reasonable.

Keep Your Expectations Reasonable

There are some takeaway lessons from this. If you’re a new investor and you expect to earn 15% or 20% compounded on your blue-chip stock investments over decades, you are expecting too much; it’s not going to happen.

That might sound harsh, but you must understand: Anyone who promises returns like that is taking advantage of your greed and lack of experience. Basing your financial foundation on bad assumptions means you will either do something irresponsible by overreaching in risky assets or arrive at your retirement with far less money than you anticipated. Neither is a good outcome, so keep your return assumptions conservative, and you should have a much less stressful investing experience.

What makes talking about a “good” rate of return even more confusing for inexperienced investors is that these historical rates of return—which, again, are not guaranteed to repeat themselves—were not smooth, upward trajectories. If you were an equity investor over this period, you sometimes suffered heart-pounding losses in quoted market valuation, many of which lasted for years. It’s the nature of dynamic free-market capitalism. But over the long term, these are the rates of return that investors have historically seen. 

The Balance does not provide tax, investment, or financial services and advice. The information is being presented without consideration of the investment objectives, risk tolerance or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.

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