What Is Required Rate of Return (RRR)?

What Is Required Rate of Return (RRR)?

Let me explain the required rate of return (RRR) directly: it's the minimum return you, as an investor, will accept for owning a company's stock, compensating you for the risk involved in holding it. I also use RRR in corporate finance to evaluate if potential investment projects are profitable enough.

You might hear RRR called the hurdle rate, which similarly indicates the compensation required for the risk level. If a project is riskier, it needs a higher hurdle rate or RRR compared to safer ones.

Key Takeaways

Here's what you need to know: RRR is the minimum return you accept for a stock to offset its risk. To calculate it accurately and make it useful, consider your cost of capital, returns from competing investments, and inflation. Remember, RRR is subjective; a retiree like you might tolerate less risk and accept a lower return than a young graduate with a higher risk appetite.

2 Methods to Calculate the Required Rate of Return (RRR)

You can calculate RRR in a couple of ways, either with the dividend discount model (DDM) or the capital asset pricing model (CAPM). Choose the model based on the situation you're dealing with.

Calculating RRR Using the Dividend Discount Model

If you're thinking about buying shares in a company that pays dividends, use the dividend discount model—it's ideal. A common version is the Gordon Growth Model.

This model uses the current stock price, dividend per share, and forecasted growth rate to find RRR. The formula is RRR = (Expected dividend payment / Share Price) + Forecasted dividend growth rate.

To do this: divide the expected dividend by the current stock price, then add the forecasted growth rate.

Calculating RRR Using the Capital Asset Pricing Model (CAPM)

For stocks that don't pay dividends, turn to the CAPM. This model incorporates the beta, which measures the stock's riskiness over time. A beta over 1 means it's riskier than the market, like the S&P 500, while under 1 means less risky.

It also uses the risk-free rate, often from short-term U.S. Treasuries, and the market rate of return, typically the S&P 500's annual return. The formula is RRR = Risk-free rate + Beta × (Market rate - Risk-free rate).

Calculate it by subtracting the risk-free rate from the market rate, multiplying by beta, and adding back the risk-free rate.

What Does the Required Rate of Return Tell You?

RRR is essential in equity valuation and corporate finance. It's tricky to pinpoint because it depends on your investment goals and risk tolerance. Factors like risk-return preferences, inflation, and capital structure influence a company's RRR, affecting a security's intrinsic value.

Using CAPM, a high-beta stock needs a higher RRR to compensate for added risk. Essentially, you add a risk premium to the risk-free rate. For projects, RRR decides if you proceed, though some might not meet it but benefit the company long-term.

To make RRR meaningful, factor in your cost of capital, competing returns, and inflation for the real rate.

Example of RRR Using the Dividend Discount Model (DDM)

Suppose a company pays a $3 annual dividend next year, with stock at $100 and a 4% growth rate. Then RRR = 7% or (($3 / $100) + 4%).

Example of RRR Using the Capital Asset Pricing Model (CAPM)

Assume a 2% risk-free rate and 10% market return. Company A has beta 1.50, so RRR = 14% or (2% + 1.50 × (10% - 2%)). Company B has beta 0.50, so RRR = 6% or (2% + 0.50 × (10% - 2%)). You'd demand more from Company A due to higher risk.

Required Rate of Return vs. Cost of Capital

RRR isn't the same as cost of capital in budgeting. Cost of capital covers debt and equity costs for funding. It's the minimum to match capital structure, and RRR should exceed it.

Limitations of the Required Rate of Return

RRR doesn't include inflation expectations, which can erode gains, and those expectations can be inaccurate. It varies by your risk tolerance—a retiree accepts less than a new graduate. It ignores liquidity; illiquid investments carry more risk. Comparing across industries is hard due to differing betas. Use multiple metrics for analysis.

What Is the Difference Between the Internal Rate of Return and the Required Rate of Return?

Internal rate of return measures annual growth; pursue if it exceeds RRR.

Should the Required Rate of Return Be High or Low?

High RRR means high risk; low RRR means low risk.

What Is Considered a Good Return on an Investment?

About 7% per year or higher, matching inflation-adjusted S&P 500 average.

The Bottom Line

RRR guides whether to expand, invest, or buy stocks by assessing risks, varying by your tolerance. Use models to calculate it, but remember it skips inflation and liquidity. Compare to other opportunities as a benchmark.