Required Rate of Return (RRR) Definition
The required rate of return (RRR) is the minimum return an investor will take in exchange for taking on a certain degree of risk in keeping a company’s stock. In corporate finance, the RRR is used to determine the profitability of prospective new investments.
The hurdle rate, like the RRR, signifies the remuneration required for the level of risk present. Projects with higher hurdle rates, or RRRs, have greater RRRs than those with lower RRRs.
Calculating the Required Rate of Return Using Two Methods (RRR)
The dividend discount model (DDM) or the capital asset pricing model are two methods for calculating the needed rate of return (CAPM). The formula used to calculate the RRR is determined by the scenario in which it is applied.
Using the Dividend Discount Model to Calculate the Required Rate of Return (RRR)
The dividend discount model is useful for investors mulling purchasing equity shares in a firm that carries out dividend payments. The Gordon Growth Concept is a well-known version of the dividend discount model.
The dividend-discount model uses the current stock price, the dividend payment per share, and the expected dividend growth rate to determine the RRR for equity of a dividend-paying firm. The following is the formula: (Expected dividend payout / Share Price) + Dividend Growth Rate Forecasted
Using the dividend discount model to calculate RRR, firstly, split the anticipated dividend payment by the current stock price and add the sum to the dividend growth rate predicted.
Calculating RRR with the Capital Asset Pricing Model (CAPM)
The capital asset pricing model (CAPM), which is commonly employed by investors for equities that do not pay dividends, is another technique to compute RRR.
The beta of an asset is used in the CAPM model to calculate RRR. The risk factor of a holding is known as beta. In another sense, beta aims to evaluate a stock’s or investment’s volatility over time. Companies with betas higher than one are regarded riskier than the entire market (which is frequently represented by a benchmark equity index, such as the S&P 500 in the United States or the TSX Composite in Canada), while stocks with betas less than one are regarded less volatile.
RRR = Risk-free rate of return + Beta X (Market rate of return – Risk-free rate of return)
What Does the RRR (Required Rate of Return) Indicate?
The return on investment (RRR) is a crucial term in stock valuation and corporate finance. Because individual individuals and financials have various investment goals and risk thresholds, it’s a challenging indicator to pin down. The firm’s own needed rate is determined by risk-return choices, inflation predictions, and the capital structure of the company. Each one of these, as well as other variables, can have a significant impact on a security’s inherent worth.
The necessary rate of return for a stock with a high beta relative to the market should have a higher RRR for investors utilizing the CAPM formula. The larger RRR compared to other low beta investments is required to compensate investors for the increased risk associated with investing in the higher beta stock.
To put it another way, RRR is computed in part by applying the risk premium to the predicted risk-free rate of return to pay for the increased market volatility.
RRR helps decide if to follow one project over another when it comes to capital projects. It is required to proceed with the project, while certain initiatives may not fulfill the RRR but are in the company’s long-term interests.
To determine the RRR correctly and to make it more significant, the investor must take into account their capital cost as well as the returns available from other rival investments. In addition, to achieve the real (or inflation-adjusted) rate of return, inflation must be incorporated into RRR analysis.
Limitations of RRR
Inflation predictions are not factored into the RRR calculation because rising prices reduce investment rewards. Inflation expectations, on the other hand, are subjective and can be incorrect.
Furthermore, the RRR will range between investors with varying levels of risk tolerance. A retiree’s risk tolerance will be lower than that of a fresh college graduate. As a result, the RRR is a rate of return that is personal.
The liquidity of an investment is not taken into account by RRR. If security can’t be sold for a long amount of time, it’s likely to be riskier than one that is more liquid.
Furthermore, comparing stocks in different industries can be challenging due to differences in risk or beta. When analyzing investment opportunities, it’s preferable to use numerous ratios, just like any other financial ratio or measure.