What is Required Rate of Return Formula?
The formula for calculating the required rate of return for stocks paying a dividend is derived by using the Gordon growth modelUsing The Gordon Growth ModelGordon Growth Model is a Dividend Discount Model variant used for stock price calculation as per the Net Present Value (NPV) of its future dividends. . This dividend discount model calculates the required return for equity of a dividend-paying stock by using the current stock price, the dividend payment per share, and the expected dividend growth rate.
The formula using the dividend discount model is represented as,
On the other hand, for calculating the required rate of return for stock not paying a dividend is derived using the Capital Asset Pricing ModelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market. (CAPM). The CAPM method calculates the required return by using the beta of security, which is the indicator of the riskiness of that security. The required return equation utilizes the risk-free rate of return and the market rate of return, which is typically the annual return of the benchmark index.
The formula using the CAPM method is represented as,
Steps to Calculate Required Rate of Return using the Dividend Discount Model
For stock paying a dividend, the required rate of return (RRR) formula can be calculated by using the following steps:
- Firstly, determine the dividend to be paid during the next period.
- Next, gather the current price of the equity from the stock.
- Now, try to figure out the expected growth rate of the dividend based on management disclosure, planning, and business forecast.
- Finally, the required rate return is calculated by dividing the expected dividend payment (step 1) by the current stock price (step 2) and then adding the result to the forecasted dividend growth rate (step 3) as shown below,
Required rate of return formula = Expected dividend payment / Stock price + Forecasted dividend growth rate
Steps to Calculate Required Rate of Return using CAPM Model
The required rate of return for a stock not paying any dividend can be calculated by using the following steps:
Step 1: Firstly, determine the risk-free rate of return, which is basically the return of any government issues bonds such as 10-year G-Sec bonds.
Step 2: Next, determine the market rate of return, which is the annual return of an appropriate benchmark index such as the S&P 500 index. Based on this, the market risk premium can be calculated by deducting the risk-free return from the market return.
Market risk premium = Market rate of return – Risk-free rate of return
Step 3: Next, compute the beta of the stock based on its stock price movement, vis-à-vis the benchmark index.
Step 4: Finally, the required rate of return is calculated by adding the risk-free rate to the product of beta and market risk premiumMarket Risk PremiumThe market risk premium is the supplementary return on the portfolio because of the additional risk involved in the portfolio; essentially, the market risk premium is the premium return investors should have to make sure to invest in stock instead of risk-free securities. (step 2) as given below,
The required rate of return formula = Risk-free rate of return + β * (Market rate of return – Risk-free rate of return)
Examples of Required Rate of Return Formula (with Excel Template)
Let’s see some simple to advanced examples to understand the calculation of the Required Rate of Return better.
Let us take an example of an investor who is considering two securities of equal risk to include one of them in his portfolio.
Determine which security should be selected based on the following information:
Below is data for calculation of the required rate of return for Security A and Security B.
|Particulars||Security A||Security B|
|Current Stock Price||$160||$100|
|Forecasted Dividend Growth Rate||5%||4%|
The required return of security A can be calculated as,
Required return for security A = $10 / $160 * 100% + 5%
The required return for security A= 11.25%
The required return of security B can be calculated as,
Required return for security B = $8 / $100 * 100% + 4%
The required return for security B = 12.00%
Based on the given information, Security A should be preferred for the portfolio because of its lower required return gave the risk level.
Let us take an example of a stock that has a beta of 1.75, i.e., it is riskier than the overall market. Further, the US treasury bond’s short term return stood at 2.5% while the benchmark index is characterized by the long term average return of 8%. Calculate the required rate of return of the stock based on the given information.
- Given, Risk-free rate = 2.5%
- Beta = 1.75
- Market rate of return = 8%
Below is data for the calculation of a required rate of return of the stock-based.
|Risk Free Rate||2.50%|
|Beta of the Stock||1.75|
|Market Rate of Return||8.00%|
Therefore, the required return of the stock can be calculated as,
Required return = 2.5% + 1.75 * (8% – 2.5%)
Therefore, the required return of the stock is 12.125%.
Relevance and Uses
It is important to understand the concept of the required return as it is used by investors to decide on the minimum amount of return required from an investment. Based on the required returns, an investor can decide whether to invest in an asset based on the given risk level.
The required return for a stock with a high beta relative to the market should have been higher because it is necessary to compensate investors for the added level of risk associated with the investment. Also, an investor can use the required returns for ranking the assets and eventually make the investment as per the ranking and include them in the portfolio. In short, the higher the expected return, the better is the asset.
This article has been a guide to the Required Rate of Return Formula. Here we discuss how to calculate the Required Rate of Return using practical examples along with downloadable excel templates. You may learn more about Valuation from the following articles –