WSU Lexicon: Equity Investments

Required Rate of Return

The required rate of return is the lowest return an investor will accept for holding an asset, given its risk. It is set by risk, not by the investor's cash flow forecast, and in valuation it serves as the discount rate. For equity it is commonly estimated with the CAPM; for the issuer it is the cost of capital.

Seen from the issuer's side, the same quantity is the cost of capital.

The entry

What Sets the Minimum

A required return has two building blocks. The first is the reward for waiting: the risk-free rate, which compensates for the time value of money and for expected inflation. The second is a premium for bearing risk, which depends on how much and what kind of risk the asset carries. Debt investors look at default risk, liquidity and maturity; equity investors, in the CAPM view, are paid only for systematic risk, the part that diversification cannot remove.

Because it is a demand made by investors, the required return is not something an analyst observes. It is inferred from models, from market data such as yields on comparable bonds, and from judgment. Two analysts can reasonably disagree about it, and small differences matter a great deal in valuation.

The entry

The Required Return as a Discount Rate

In valuation, the required return becomes the discount rate. A dividend discount model divides each expected dividend by one plus the required return, raised to the number of periods until it is received; in the constant-growth version, V₀ = D₁ / (r − g), with g the dividend growth rate and r the required return on equity. Because r sits in the denominator, a higher required return lowers the estimate of value.

The rate must match the cash flow being discounted. Dividends and free cash flow to equity are discounted at the required return on equity; free cash flow to the firm, which belongs to all providers of capital, is discounted at the weighted average cost of capital. Mixing the two produces a value that answers neither question.

The entry

Required Versus Expected Return

The required return is set by risk; the expected return is set by price and forecasts. Comparing the two is the core of a buy or sell decision. If an investor expects a share to return 11% at today's price and its required return is 9%, the share appears undervalued, because the price is low relative to the cash flows the investor anticipates. If the expected return were 7%, the share would appear overvalued.

In equilibrium, when price equals intrinsic value, the two returns coincide. That is why a CAPM output can be called an expected return only when the equilibrium assumption is explicit. When the output is used to discount cash flows or to judge mispricing, it should be labeled the required return.

The entry

From Investor Demand to Corporate Hurdle

What investors require, companies must pay. From the issuer's side, the required returns of lenders and shareholders become the company's costs of debt and equity, and their weighted average is the company's cost of capital. Projects with the same risk as the existing business must earn at least that weighted average to create value; riskier projects need a higher rate.

Candidates should be able to estimate the required return on equity with the CAPM, use it in dividend and free cash flow models, and explain how a change in the risk-free rate, beta or the market risk premium alters both the required return and the resulting estimate of value.

Common trap

“A stock with a high required return is an attractive buy.”

A high required return reflects high risk, not opportunity. Attractiveness depends on comparing the expected return, implied by price and forecasts, with the required return. A risky stock priced too high can offer an expected return below what its risk demands.

In practice

Allowed returns in utility rate cases

When US regulators set electricity and gas tariffs, they estimate the return shareholders require, often with CAPM and dividend discount models, and allow the utility to earn it on its equity. The allowed return then shapes the prices customers pay.

Candidates ask

Questions on this term

How is the required return on equity estimated?Most often with the CAPM: the risk-free rate plus beta times the market risk premium, r = r_f + βᵢ[E(Rₘ) − r_f]. Multifactor models and a bond yield plus a risk premium are common alternatives.
What is the difference between required return and expected return?Required return is what the asset's risk demands; expected return is what the investor anticipates earning, given the current price and forecast cash flows. If the price equals intrinsic value, the two are equal. If the expected return is higher, the asset appears undervalued; if it is lower, overvalued.
Is the required return the same as the cost of equity?They are the same quantity seen from two sides. Investors call it the required return on equity; the company that issued the shares calls it its cost of equity. Combined with the after-tax cost of debt and weighted by the capital structure, it forms the weighted average cost of capital. The number is not observed in the market and must always be estimated.

Related entries

Capital Asset Pricing ModelThe Capital Asset Pricing Model states that an asset's expected return equals the risk-free rate plus its beta multiplied by the equity risk premium.
Cost of EquityCost of equity is the rate of return shareholders require for holding a company's shares, given the risk they bear.
Dividend Discount ModelThe dividend discount model values a share of common stock as the present value of all expected future dividends, discounted at the investor's required return on equity.
Expected ReturnExpected return is the return an investor anticipates earning on an asset over a period, given today's price and the cash flows the investor forecasts.

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Required Rate of Return

Seen from the issuer's side, the same quantity is the cost of capital.