What Is Required Rate of Return (RRR)?
The required rate of return (RRR) 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 the minimum return an investor will accept for owning a company's stock, to compensate them for a given level of risk.
- To accurately calculate the RRR and improve its utility, the investor must also consider his or her cost of capital, the return available from other competing investments, and inflation.
- The RRR is a subjective minimum rate of return; this means that a retiree will have a lower risk tolerance and therefore accept a smaller return than an investor who recently graduated college and may have a higher appetite for risk.
The RRR 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
Two Methods to Calculate Required Rate of Return (RRR)
There are a couple of ways to calculate the required rate of return—either using the dividend discount model (DDM), or the capital asset pricing model (CAPM). The choice of model used to calculate the RRR depends on the situation for which it is being used.
Calculating Required Rate of Return (RRR) Using the Dividend Discount Model
If an investor is considering buying equity shares in a company that pays dividends, the dividend discount model is ideal. A popular variation of 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:
RRR = (Expected dividend payment / Share Price) + Forecasted dividend growth rate
To calculate RRR using the dividend discount model:
- Take the expected dividend payment and divide it by the current stock price.
- Add the result to the forecasted dividend growth rate.
How to Calculate Required Rate of Return
Calculating Required Rate of Return (RRR) Using the Capital Asset Pricing Model (CAPM)
Another way to calculate RRR is to use the capital asset pricing model (CAPM), which is typically used by investors for stocks that do not 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 (often represented by a benchmark equity index, such as the S&P 500 in the U.S., or the TSX Composite in Canada), 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:
RRR = Risk-free rate of return + Beta X (Market rate of return - Risk-free rate of return)
To calculate RRR using the CAPM:
- Subtract the risk-free rate of return from the market rate of return.
- Multiply the above figure by the beta of the security.
- Add this result to the risk-free rate to determine the required rate of return.
What Does the Required Rate of Return (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 tolerances 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.
To accurately calculate the RRR and make it more meaningful, the investor must also consider their cost of capital, as well as the return available from other competing investments. In addition, inflation must also be factored into RRR analysis so as to obtain the real (or inflation-adjusted) rate of return.
Example of Required Rate of Return (RRR) Using the Dividend Discount Model (DDM)
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) + 4% growth rate)
Example of Required Rate of Return Using the Capital Asset Pricing Model (CAPM)
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 (called the equity risk premium).
Assume the following:
- 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%.
Let's say Company A has a beta of 1.50, meaning that it is riskier than the overall market (which has a beta of 1).
To invest in Company A, RRR = 14% or (2% + 1.50 X (10% - 2%))
Company B has a beta of 0.50, which implies that it is less risky than the overall market.
To invest in Company B, RRR = 6% or (2% + 0.50 X (10% - 2%))
Thus, an investor evaluating the merits of investing in Company A versus Company B would require a significantly higher rate of return from Company A because of its much higher beta.
Required Rate of Return 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 equity issuance 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 Required Rate of Return (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.