How to Calculate Required Rate of Return
You have kept some money away and have finally decided to put it to use.
Whether you kept it in a bank’s savings account or it is money received from another source, you want it to grow.
And what better way than to invest it?
With investments, you have many options and picking one isn’t easy.
But something that’s even more difficult is deciding where to invest.
Do you buy the shares of company A or B or C? Do you ditch the stocks and go for a government bond?
Which is better between company shares and government bonds? Why are some people die-hard fans of stocks while others swear by bonds? What’s the difference?
If you are new to investing, you might have an easier time going for bonds.
These are sure investments with very little risk associated with them.
Bonds do not necessarily need expert analysis as they are pretty straightforward.
Some can however have some clauses which you may need to understand first as they may affect your returns.
The low risk levels of bonds makes them pay out lower returns. And the less the amount you put in, the less you will make out.
Stocks on the other hand are more risky and better-paying. You simply get more earnings for risking your money.
The risk associated with stock prices comes from the fluctuations they experience.
The stock price of a company may be at $40 today. Tomorrow morning, it may rise to $42. Come afternoon, due to a decision announced by the CEO, the price could fall back to $40.
As investors and market analysts discuss the effect of the decision made, the stock could close the day at $35.
This kind of volatility is not everyone’s cup of tea.
Not everyone is able to respond quickly to mitigate the risk involved in not selling at the right time.
Required Rate of Return defined
It is this scenario that makes investors want to forecast how much they are going to make before investing.
Since stocks generally provide higher returns than bonds, flocking to the stock market can only be a natural response.
Choosing stock investment is great, but you have to choose the right company beforehand.
To avoid losing your money, it is important that you try to predict your potential returns.
One of the ways of doing that is by calculating the required rate of return (RRR).
The required rate of return is the minimum rate of earnings you are willing to take from a given investment.
It is more of a threshold you set for yourself so that any investment which promises anything less than that will simply not warrant your attention.
This will make it easy for you to make an investment decision.
This rate will provide the necessary guide to choose between any two or more options.
Being required means that this rate is a set standard.
And who sets the standard?
It is you.
There is no agency or organization which can set this for any investor. The only thing someone may do is to advise you based on your unique circumstances.
As such, the RRR is a subjective approach to calculating potential investment returns.
What influences the required rate of return?
There are at least three factors which will make the required rate of return differ between investors.
This is why there cannot be a published rate given as a blanket guide for everyone.
Here is a brief discussion of the three factors.
1. Risk tolerance levels – risk tolerance is the capacity to tolerate or take risk. In other words, risk tolerance asks the question, “How much risk can you take?” The more risk you can handle, the higher your risk tolerance The less risk, the lower your risk tolerance is.
This is important because every investor is different.
Whereas some people are very risk averse, some are very comfortable with the idea of risking their money.
This latter group is the one which would rather put their money in the government bonds.
If you are adventurous enough to risk your money, then it will be wise to know the level of risk you are willing to take.
You may need to study the market or get a good analyst to help you make quick decisions.
2. Investment goal – every investment made has a goal it wants to achieve. You may want to purchase a home in two years or buy a car. You may want to raise enough money for college or even to start your own business. Whatever the goal, your investment is your trusted means to achieve it.
With goals being different, simply because humans are different, then you need to know which kind of investment will best get you what you are aiming for.
Some investments will give quick yields while others will be slower.
Intending to use an investment to reach a specific goal requires that you study the market a bit.
You will need to understand the industry you are investing in. within the industry itself, you will need to know how different companies conduct business and how that affects their stock prices.
This will help you be more certain of where to put your money.
3. Investment duration – how long do you want your money to remain invested? To answer this question, you need to have your investment goal clear. If you want to go to college next year, it means you only have 1 year to get the money needed.
Therefore, your investment goal will be what determines your investment duration. Your investment duration will then determine which stocks you can buy.
If you go for one which doesn’t grow quickly, you may get to December without much to celebrate.
This calls for an understanding of how investments work.
First, find out which industry is growing faster than the others. Then find out what is making it grow. This is what you will be watching because anything happening to it will affect stock prices.
Next ask yourself, “Which company in this industry is showing the greatest potential?” Dig into the history of the prices. What are trends? What have analysts been saying?
Equip yourself accordingly, otherwise, invest in an experienced analyst who can advise you. The only drawback to using an analyst is that you will likely be paying him.
If you are willing to learn something new, investing is not hard. It is also fun.
And who knows, you might turn out to be the newest and best analyst in town.
REQUIRED RATE OF RETURN CONSIDERATIONS
In your quest to come up with a non-negotiable threshold, there are some things to consider.
These will help you make accurate calculation and not come up with a rate which will hurt you.
When it comes to the RRR, these are the terms and conditions.
It Doesn’t Factor in Inflation
Your investment will always be affected by inflation rates. And not only your investment, but also your returns.
If inflation rises, then life becomes more expensive.
When life is expensive, the value of money goes down as it is no longer able to buy what it used to buy.
This means that the money investors have set aside for investment will reduce as they take care of other life matters.
Eventually, investments will reduce. Demand for stocks will go down as the supply either remains or goes up as companies look for more money.
On the side of inflation and your returns, the money you get will also be subject to inflation. Inflation will affect your purchasing power and so your returns will be of lower value in case of a higher inflation rate.
Bearing this in mind, any time you are calculating the required rate of return, you have to factor in inflation.
If you do your math an come up with a rate of say 4%, then you will simply add the inflation rate so as to cushion yourself.
It Doesn’t Factor in Investment Liquidity
Liquidity is the ease of selling something off and getting cash. Investments have a liquidity which you have to determine.
This you do by looking at how easy it is to trade them.
If a stock is liquid, then it can easily be traded. This comes down to the demand which is affected by among other things, the profitability of the company or industry.
If the investment you are about to make may not be salable for a duration of time, then it bears more risk.
If you are to go ahead with that investment, then you have to require a higher return from it.
This is in line with the investment rule that the higher the risk, the higher the return.
REQUIRED RATE OF RETURN VS EXPECTED RATE OF RETURN
The investment world is full of words which may leave you a bit confused. Some may seem very similar.
Two potentially confusing terms we will look at are the required rate of return and the expected rate of return.
The required rate of return, as we have already mentioned, is the minimum investment return you can consider before putting your money into it. It is the threshold. If an investment doesn’t make it past the threshold, you simply keep your money and continue searching.
The expected rate of return is different.
This is the return you are looking to receive from an investment. For you to calculate the expected rate of return, the investment must have first of all passed the required rate of return test.
You will then be seeking to find out just how much you are going to make in that particular investment.
To make it easy to differentiate these two, just remember that one is the determining factor while the other is the profitability factor.
One dictates whether to invest, the other tells you how much you will get after you invest.
The Risk Factor
It is of great importance to understand that investments are risky, especially in the stock market.
If you want guaranteed returns, then look to the risk-free investments which come in the form of bonds. Those however have lower returns.
If you go for stocks, you better start befriending risk.
The required rate of return and the expected rate of return should never be your guarantee of success. Investments come with many factors to be considered.
Understand the market volatility and know that you may get higher or lower returns than what you predicted.
REQUIRED RATE OF RETURN FORMULAS
With sufficient knowledge on the basics of RRR, it’s time to look at how to calculate it. Calculating the RRR will usually take either of two formulas.
The first is the Dividend Discount Model and the other is the Capital Asset Pricing Model.
Dividend Discount Model
You will use this model when considering an investment into shares which normally pay dividends. This model is also called the Gordon Growth Model.
One assumption which you have to make when using this model is that the dividend payout grows at a constant rate.
This can be determined by looking at the dividend payments done over the course of several years.
The formula for this model is as below.
RRR = (Expected dividend payment / Current share price) + Dividend growth rate
Since company X became public, it has been paying its shareholders a dividend which grows by 5%. Next year, it is expected that it will pay a dividend of $3 per share. The company’s stock is currently trading at $80.
If you were to invest in company A, this is how you would calculate the required rate of return.
RRR = (3 / 80) + 0.05 = 0.0875 i.e. 8.75%
Considering that RRR doesn’t consider inflation rates, given an inflation rate of 2%, an RRR of 8.75% means that your returns would actually be 6.75%.
If the investment is promising something bigger than 8.75%, then it’s a worthy investment.
Capital Asset Pricing Model
Not all stocks pay dividend. When considering an investment into such stocks, then the formula to use is the Capital Asset Pricing Model (CAPM).
This model uses three variables to calculate the RRR.
These are the beta of the investment, the average market rate of return and the rate of return on a risk-free investment.
Let’s look at these variables before getting to the formula.
- Beta is the risk coefficient of an investment. It is the level of risk an investment carries. In more technical terms, it is the measure of an investment’s volatility compared to the market return.
The beta of investments are usually available in financial publications. When an investment has a beta of 1, it means that it will fluctuate with the market.
If it is less than 1, then it is less volatile than the market. If more than 1, then it is riskier than the market average.
- Average market rate of return – this is the return which the market experiences on average. For example, there is an average return which investors in the car manufacturing industry usually get. Like the betas, these returns are available from S&P, the Dow or NASDAQ.
- Risk-free rate of return – this is the rate of return you get from risk-free investments. To be on the safe side, you should use the highest risk-free rate which is applicable to you.
There are two places to look for this rate.
One is your local bank. The risk-free rate from them is the interest rate they give you for a cash deposit. You can also consider the short-term US treasury securities.
These give a return rate which is guaranteed, though low.
The CAPM formula takes these three variables and uses them to calculate the RRR of an investment. The formula is:
RRR = Risk-free rate of return + beta (average market rate of return – Risk-free rate of return)
Company A has a beta of 1.2. This value indicates that the stock is riskier than the average market’s beta of 1. The average market rate of return is 7%.
The banks give an interest of 1.5% on cash deposit for a savings account while the US securities are giving 2%.
For the CAPM calculations, you will use the 2% from US securities as the risk-free rate of return.
This is because you are looking to gain more than the US bonds can give you. Using this example, the calculation of your RRR will be:
RRR = 0.02 + (1.2 (0.07 – 0.02)) = 0.08 i.e. 8%
Using this model, the minimum rate of return you can risk your money for is 8%.
Any investment promising a return rate greater than 8% will be worth considering.
With these two formulas, you can confidently gauge the profitability of an investment.
All the same, keep in mind that it is very difficult to predict the risk factor of an investment with 100% accuracy.
As such, these formulas remain to be guides but not assurances.
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