Enter the risk-free rate, beta coefficient of the stock, and the expected return from the market into the calculator to determine the required rate of return.
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Required Rate of Return
Many investors (and many actively managed funds) do not consistently beat a broad market index over long periods after fees and taxes. Investing in any asset involves risk, so investors often use a required rate of return to judge whether an investment’s expected return is sufficient for the risk taken.
The RRR helps companies compare one investment to another and determine if a project is worth it.
Let’s look at the required rate of return in greater detail.
What is the Required Rate of Return?
The required rate of return (RRR) is the minimum annual return (usually stated as a percentage) that an investor requires to be compensated for an investment’s risk. In corporate finance, it is often used as a hurdle rate or discount rate when evaluating projects or investments.
Generally, investments that are expected to deliver higher returns also carry higher risk, although the relationship is not guaranteed in every situation.
In addition, the required rate of return is used to compare an investment’s expected return to its cost of financing (for example, the company’s cost of capital).
How Do You Calculate The Required Rate of Return?
The Capital Asset Pricing Model (CAPM) can be used to estimate the Required Rate of Return Formula.
The CAPM model is commonly used to estimate the return investors require for a risky investment based on its market risk (beta).
Inflation can affect nominal returns. CAPM is typically applied using nominal rates (not inflation-adjusted); if you want a real (inflation-adjusted) required return, use real inputs or convert nominal rates to real rates consistently.
Required Rate of Return Formula
The following formula is used to calculate the required rate of return of an asset or stock.
RR = RFR + B * (RM-RFR)
- Where RR is the required rate of return
- RFR is the risk-free rate of return
- B is the beta coefficient of the stock or asset
- RM is the expected return of the market
To calculate the required rate of return, subtract the risk-free rate from the expected market return, multiply this by the beta coefficient, then add the result to the risk-free rate. (Make sure all rates use the same units—either all in percent or all in decimals.)
What Is a Bad Rate of Return?
A “bad” rate of return depends on your goals and risk level. In general, a realized return is unfavorable if it is negative or if it falls below your required rate of return (meaning you were not compensated for the risk you took).
If the investment’s losses or costs end up exceeding the gains, the investor will likely wind up with less than they started with.
There is no single “decent” return that applies to all investments. As a rough reference point, long-term U.S. stock market returns have historically been in the high single digits to around 10% per year on a nominal basis (and lower after adjusting for inflation), but actual results vary by period and asset class.
What Is a Real Rate of Return?
The real rate of return is the return adjusted for inflation, so it reflects the change in purchasing power. It can be approximated as nominal return minus inflation for small rates, or calculated more precisely as (1 + nominal return) / (1 + inflation) − 1.
Returns that account for taxes are usually described as after-tax returns. After-tax and real returns are different adjustments (although both can be applied if needed).
When comparing investment performance, it’s often helpful to consider both inflation and taxes, since both can reduce what you keep in real (purchasing-power) terms.
What Is The Required Rate of Return on Equity?
The required rate of return on equity (often called the cost of equity) is the return shareholders require for providing equity capital to a company. It is used as a discount rate for cash flows that are financed by equity (including retained earnings or newly issued stock).
It’s also the estimated return necessary for a shareholder to be willing to hold the stock, given its risk.
The rate of return indicates how much earnings you’ve gained from a particular project over a given timeframe, but the return on equity is a stock- and company-specific measure that relates profits to shareholders’ equity.
What Is a Reasonable Rate of Return During Retirement?
In retirement planning, “reasonable” return assumptions vary by portfolio mix, fees, inflation, and time horizon. Many long-term plans use a mid-single-digit nominal return assumption (often roughly 4% to 7%), but the appropriate figure depends on your investments and how conservative you want the plan to be.
