The required rate of return, also known as the target rate of return, is the Required Rate of Return in English, or RRR for short, which refers to the minimum rate of return that investors expect to get from their investment. Usually expressed as a percentage, it is an important factor in evaluating whether an investment is worthwhile. Investors usually compare possible investments with their necessary rate of return. If the expected return of the investment is higher than or equal to the necessary rate of return, then the investment may be a good choice. For example, if an investor believes that the minimum rate of return (required rate of return) on investment should be 10%, then the investor will use this 10% to evaluate an investment rate. If the return on an investment is less than 10%, investors are less likely to consider it. The level of required rate of return also means the level of investment risk. The higher the required rate of return, the higher the return, but the higher the risk. On the contrary, investments with lower required rate of return are relatively stable investment objects. It should be noted that the required rate of return does not take into account the impact of investment duration on returns. For example, if an investment cannot obtain a return for many years, the investment risk will increase, but this cannot be reflected in the necessary rate of return. Similarly, the investment risk caused by inflation cannot be reflected in the necessary rate of return. For a company, its Weighted Average Cost of Capital (WACC) can be viewed to some extent as the company's necessary rate of return when evaluating any investment. 1. Calculated using the Capital Cost Pricing Model (CAPM) CAPM is calculated by adding the zero-risk return of an investment to the risk premium, which can be expressed as: Required rate of return = risk-free rate + β x (market rate of return – risk-free rate) Re = Rf + β (Rm – Rf) Among them: Re: Required rate of return refers to investors’ expected rate of return on stocks; Rf: Risk-Free Rate. The risk-free rate usually matches the government bond interest rate of the country where the investment is made. The bond period should also correspond to the time limit of the investment. However, in the investment field, the ten-year government bond interest rate is usually used as the zero-risk interest rate by default, because the ten-year government bond is usually the highest quoted and most liquid bond type. In the United States, the ten-year Treasury bond rate is also used as the risk-free interest rate value. β: Beta coefficient is a coefficient that measures the risk of a stock relative to the entire market, that is, the systematic risk coefficient of a stock relative to the entire stock market. A stock with a beta greater than 1 is riskier than the market as a whole, while a stock with a beta less than 1 is relatively less risky. From the β coefficient, we can also see investors’ expected return on the stock. The higher the β value, the higher the investor’s expected return on the stock. Beta coefficients can be obtained from financial websites such as Barron's, or can be calculated by performing regression analysis on stock returns and market returns. Rm: Market expected return (Return of the Market). In the U.S. investment market, the historical average return or expected return of the S&P 500 is usually used as the market expected return. Calculated based on the historical return rate of the S&P 500, its average return rate fluctuates around 10%. Therefore, 10% is usually selected as the market's expected return rate. (Rm – Rf): Risk premium (Market Risk Premium) refers to the additional return for investors in addition to the risk-free interest rate. It is the additional return that compensates investors for investing in risky products. The greater the volatility of a stock, the higher its investment risk, the higher the investor's expected rate of return, and the higher the risk premium. 2. Use weighted average cost of capital (WACC) Weighted average cost of capital (WACC) is a financial indicator of a company, which reflects the cost that the company pays to obtain funds (including equity and debt). WACC is the weighted average of a company's expected rate of return from all sources of capital (including stock, debt, preferred stock, etc.). A company's WACC can be considered, to some extent, as the required rate of return for investors.
That is, if the expected rate of return on a company's investment project is lower than the company's WACC, this indicates that the project cannot generate enough income to cover the company's cost of capital, which may have a negative impact on the company's shareholder value. Therefore, generally speaking, when companies evaluate investment projects, they will hope that the expected rate of return of the project is at least higher than the WACC. To find out how a company's weighted average cost of capital (WACC) is calculated, see the article How to Calculate the Weighted Average Cost of Capital . Required rate of return calculation example Below, we will use relevant data from Apple to perform example calculations. The CAMP model is used for calculation here. First, we check that the yield on the U.S. ten-year Treasury bond is 2.74% (July 2022), so Rf = 2.74%. The average return on the S&P 500 is 10%, so, Rm = 10% According to data published by Barrons, as shown below, Apple’s current β = 1.22 Therefore, you can calculate the necessary rate of return based on the above parameters: Re = Rf + β x (Rm – Rf) = 2.8857% + 1.22 x (10% – 2.8857%) = 11.56% Therefore, according to the calculation of the capital cost pricing model, Apple's current CAPM value, that is, the necessary rate of return is 11.56%. What investment guidance does the required rate of return have? The necessary rate of return is considered to be the minimum rate of return that investors can accept when investing. Investors can compare it with the expected return of the investment object: When the necessary rate of return > the expected return rate of the investment object, it means that the return that the investment can bring does not reach the investor's expected minimum return value, and it is very likely that the investor will no longer consider investing in the object. When the necessary rate of return < the expected return rate of the investment object, it means that the investment can meet the investor's minimum expectations, so more consideration will be given to the investment. Another use of required rate of return is to evaluate the risk level of investment objects: When the required rate of return is higher, it means that the risk level of the investment is higher; When the required rate of return is lower, it means the investment is less risky. The necessary rate of return can also be used in the Gordon growth model (GGM), also known as the "dividend discount model". This model considers the intrinsic value of a stock under the premise that dividends grow at a constant rate. It is calculated by dividing the expected annual dividend per share by the difference between the necessary rate of return and the dividend growth rate, that is: Stock value = expected annual dividend per share ➗ (required rate of return – dividend growth rate) Stock Value = Anticipated Yearly Dividends / (RRR -G) When the calculation result is higher than the current stock price, the current stock price is considered to be undervalued and it is a suitable time to invest; When the result is lower than the current stock price, the current stock price is considered overvalued and it is more suitable to wait and see. What are the limitations of using required rate of return? The biggest limitation of the required rate of return is that it does not take into account the impact of time on value. If an investment cannot recover the investment cost within many years, it essentially increases the investment risk, but this situation is not reflected in the calculation of the necessary rate of return, so investors cannot consider this risk in the calculation. At the same time, the impact of inflation on assets is not reflected in the calculation of necessary rate of return. If a high inflation rate occurs during the investment process, it will also directly bring investment risks. More investment basics What is the CFTC? CFTC What are Credit Default Swaps? Credit Default Swaps What is a "petrodollar"? Petrodollar What is technical analysis? Technical Analysis What is fundamental analysis? Fundamental Analysis What is a short trade? Short Selling Year-on-year vs month-on-month? MoM, QoQ, YoY
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