Required Rate of Return

Whenever I meet someone new and am asked the obligatory “what do you do?” I typically get two reactions. Roughly half of folks respond with an unconscious grimace and politely excuse themselves in search of someone more interesting.  The second reaction is one of delight and surprise.

Once this exchange happens with an interested party, the next question I usually get is – what stocks do you like? Now I’m the one grimacing.  The reason being is that stocks are as varied as the investors who own them.  In addition to first understanding an investor’s risk tolerance, time horizon, and long-term goals, picking stocks requires a lot of analysis.  One of the cornerstones of equity analysis begins with something called the required rate of return. If you’re not already grimacing, read on brave reader!

A required rate of return effectively measures what kind of payback you need to get in order to go forward with a stock (or any investment) purchase. To determine a stock’s required rate of return you need three inputs: (1) the economy’s real risk-free rate of return (2) the expected inflation rate and (3) a risk premium to make-up for the added uncertainty that comes with owning a stock.  The first input, the real risk-free rate of return is a return you can theoretically get today with virtually no risk.  We plan to own our stock for ten years, so we’ll use the 10 Yr Treasury bond as our risk-free rate proxy, currently yielding ~2.5%.  We start with the “risk-free” rate because if nothing else, the stock you’re considering should at least deliver a return on par with a very safe US Treasury bond.  And then some, because you need to be compensated for the additional risk you’re about to take.  More on that in a minute.

Next, rising costs will diminish the purchasing power of your dollar over time, so you’ll want to have an investment that at least offsets the deleterious effects of inflation. Expected inflation is currently running around 2%, so we’ll add that to our risk-free rate of 2.5% for a required stock return (so far) of 4.5%.  Finally, because of the added risk you take on by owning a stock, you should demand some kind of compensation for this uncertainty.  We account for this risk by taking a stock’s beta or its volatility compared to the market, and multiplying it by an equity risk premium.  The equity risk premium is generally estimated by subtracting the expected equity market return (stocks have returned 10% on average over the long-term*) from the risk-free rate.  Thus, our equity risk premium is 7.5% or 10% minus the risk-free 2.5%.  Phew.  Using a pretend stock, Widgets-R-Us (Ticker: WIGGY) as our prospective stock investment, with a 5-year beta of about 0.90 – meaning it has historically been less volatile than the market – we get a total risk component of 6.75% (beta x equity risk premium or 0.90 x 7.5%).  Putting it altogether we should require WIGGY to return at least 9.25% before wading in.

Congrats! You calculated a required rate of return.  Although this is an important starting point, I’m sorry to tell you it’s just the beginning.  It’s a good beginning because we now know what return we require in order to buy Widgets-R-Us, but you may have guessed that without an expected rate of return we don’t have a lot to go on.  The good news is that there are plenty of knowledgeable investment professionals who can do the work for you.  And importantly, are willing to take the time to explain how they come to their investment decisions.

*Ibbotson, large cap stocks 1926-2012

Carrie Tallman, CFA

Director of Research

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