Required Rate Of Return Formula

Updated on April 17, 2024
Article byWallstreetmojo Team
Reviewed byDheeraj Vaidya, CFA, FRM

What Is The Required Rate Of Return Formula?

The formula for calculating the required rate of return for stocks paying a dividend is derived 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. read more. 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.

What Is The Required Rate Of Return Formula

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The required return equation utilizes the risk-free rate of return and the market rate of return, typically the benchmark index’s annual return. On the other hand, 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.read more (CAPM). The CAPM method calculates the required return by using the beta of security, which is the indicator of the riskiness of that security.

Key Takeaways

  • Required rate of return is calculated by the Gordon growth model for dividend-paying stocks by analyzing stock price, dividend payment, and expected growth rate.
  • Using beta, the required return is calculated using risk-free and market rates, benchmark indexes’ annual returns, and CAPM for non-dividend equities.
  • Understanding required return is crucial for investors as it influences investment choices, asset classification, and risk-based decision-making. Higher projected returns indicate more robust asset performance and aid in risk management and wise financial decisions.

Required Rate of Return Formula Explained

The required rate of return is also known as the minimum acceptable rate of return. It is the minimum amount of money that an investor can expect to earn if they put their money into any form of project or investment. Based on this calculation, the the investor decides whether to put the money in it or not.

When an individual or a company invest funds in a project or investment avenue, they accept to take some extent of risk associated with it. This return is the compensation received against taking that risk.

The formula for required rate of return depends on factors like risk free rate of return, market risk, risk related to tat specific project and the opportunity cost of foregoing other options. The risk-free rate is the return from government bonds with zero risk, which serves as a benchmark to identify the amount of compensation that an investor should expect depending on the time value of money.

The risk associated with investment in the broader market can also be considered as a benchmark, where the market volatility and economic conditions influence the overall market performance and in turn the returns on investments. However, the particular project or investment opportunity may also be prone to some risk inherent to it which are important considerations. It may also be company specific, related to its financial conditions, rules or legal terms. They influence the required rate of return. Thus, the rate is fixed after considering all the above.  

There are some common The formula for required rate of return or methods that are commonly used to calculate this return.

The formula using the dividend discount modelDividend Discount ModelThe Dividend Discount Model (DDM) is a method of calculating the stock price based on the likely dividends that will be paid and discounting them at the expected yearly rate. In other words, it is used to value stocks based on the future dividends' net present value.read more is represented as,

Required Rate of Return formula = Expected dividend payment / Stock price + Forecasted dividend growth rate

The formula using the CAPM method  is represented as,

Required Rate of Return formula = Risk-free rate of return + β * (Market rate of return – Risk-free rate of return)
 
 

It is important to take informed financial decisions so that one can earn maximum return out of the money based on the policy of risk and return trade off.

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How To Calculate?

Let us identify the various minimum required rate of return formula that are commonly used to calculate the required rate of return on an investment.

#1- Dividend Discount Model

For stock paying a dividend, the required rate of return (RRR) formula can be calculated by using the following steps:

  1. Firstly, determine the dividend to be paid during the next period.

  2. Next, gather the current price of the equity from the stock.

  3. Now, try to figure out the expected growth rate of the dividend based on management disclosure, planning, and business forecast.

  4. 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

#2 -CAPM Model

The minimum required rate of return formula 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 the return of any government issues bonds such as 10-year G-Sec bonds.

Step 2: Next, determine the market rate of return, the annual return of an appropriate benchmark index such as the S&P 500 index. 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 stock’s beta based on its stock price movement vis-à-vis the benchmark index.

Step 4: Finally, the required rate of return formula finance 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.read more (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(with Excel Template)

Let’s see some simple to advanced examples to understand the calculation of the Required Rate of Return better.

You can download this Required Rate of Return Formula Excel Template here – Required Rate of Return Formula Excel Template

Example #1

Let us take an example of an investor 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.

ParticularsSecurity ASecurity B
Expected Dividend$10$8
Current Stock Price$160$100
Forecasted Dividend Growth Rate5%4%

The required return of security A can be calculated as,

Required Rate of Return Formula Example 1.1png

Required return for security A = $10 / $160 * 100% + 5%

Required Rate of Return Formula Example 1.2png

The required return for security A= 11.25%

The required return of security B can be calculated as,

Required Rate of Return Formula Example 1.4png

Required return for security B = $8 / $100 * 100% + 4%

Required Rate of Return Formula Example 1.5png

The required return for security B = 12.00%

Based on the given information, Security A should be preferred for the portfolio because its lower required return gave the risk level.

Example #2

Calculate the required rate of return formula finance based on the given information. Let us take an example of a stock with 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 a long-term average return of 8%.

  • 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 Rate2.50%
Beta of the Stock1.75
Market Rate of Return8.00%

Therefore, the required return of the stock can be calculated as,

Example 2.1png

Required return =  2.5% + 1.75 * (8% – 2.5%)

= 12.125%

Example 2.2png

Therefore, the required return of the stock is 12.125%.

Thus, the above examples give us an insight into how the investors who may be individuals or companies, determine the minimum amount of return that will justify the risk that they are taking while investing in various avenues. The examples help in understanding the evaluation process undertaken while deciding whether it is worth putting the money in an opportunity or there are better options for the same.

Relevance and Uses

The required rate of return has various important uses in the finance and investment analysis process. Given below are some common applications.

  • It is important to understand the concept of the required return as investors use it 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 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.
  • Thus, it helps in investment evaluation and assessing the attractiveness of the opportunity. By comparing the projected return with the required return, it is possible to understand whether it go ahead with a financial decision or not.
  • It helps companies estimate the cost of capital, which is the rate of return that will satisfy stakeholders and meet their expectations. It also helps in evaluating the possibility of merger and acquisition, determination of capital structure or assessing the viability of a project.
  • The formula also helps in managing risk because the investor can identify the trade off between the risk and reward between different options and take informed financial decision.

Frequently Asked Questions (FAQs)

What is a reasonable required rate of return?

Depending on variables, including company risk, liquidity risk, and financial risk, it may fall between 3% and 9%. Or you may calculate it using previous years’ market results.

Can the required rate of return be negative?

Many things can result in a poor ROR. An investor could purchase an oil-heavy exchange-traded fund (ETF) the day before the decline in oil prices begins. Millions of investors may experience a day or season of negative returns due to publishing a single unfavorable economic figure.

What is the required rate of return in risk-return analysis?

Investors and businesses use the required rate of return (RRR) calculation to determine the minimal sum of money they anticipate earning on their investment in a stock or project. An essential key performance indicator (KPI) for gauging a company’s success is the RRR.

Can the Required Rate of Return change over time?

Yes, the Required Rate of Return can change over time based on changes in market conditions, economic factors, and the investor’s risk tolerance. As economic conditions fluctuate, investors may adjust their RRR to align with the prevailing market conditions and investment objectives.

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