Key takeaways
– The required rate of return (RRR), or hurdle rate, is the minimum return an investor or firm requires to justify an investment given its risk.
– Two common ways to estimate RRR for equities are the Dividend Discount Model (DDM/Gordon Growth) and the Capital Asset Pricing Model (CAPM).
– RRR is used as a discount rate for valuation and as a decision threshold in capital budgeting; it is related to—but distinct from—the company’s cost of capital (WACC) and from an investment’s internal rate of return (IRR).
– RRR is inherently subjective and sensitive to input choices (risk-free rate, beta, growth rates, inflation, etc.), so apply it carefully and test alternative assumptions.
1. What is the Required Rate of Return (RRR)?
RRR is the minimum expected return an investor demands to compensate for the risk of an investment. For corporations it’s often used as the hurdle rate when deciding whether to undertake projects. Riskier investments generally require higher RRRs.
2. Two common methods to calculate RRR
– Dividend Discount Model (DDM / Gordon Growth Model): best for dividend-paying stocks with reasonably stable dividend growth.
Formula (constant-growth DDM):
RRR = (Expected dividend next period / Current share price) + Dividend growth rate
i.e., RRR = D1 / P0 + g
• Capital Asset Pricing Model (CAPM): used for stocks without dividends or when using a market-based risk measure.
Formula:
RRR = Risk-free rate + Beta × (Market return − Risk-free rate)
i.e., RRR = rf + β × (rm − rf)
3. Step-by-step: calculating RRR with the Dividend Discount Model (DDM)
Practical steps
1. Determine D1: the dividend expected next period (if you have most recent dividend D0 and expect steady growth g, then D1 = D0 × (1 + g)).
2. Determine P0: current market price per share.
3. Estimate long-term dividend growth rate g (use historical growth, analyst forecasts, or GDP/industry growth as anchors).
4. Compute RRR = D1 / P0 + g.
5. Sensitivity: test RRR across plausible g and D1 scenarios.
Example
– Expected dividend next year D1 = $3
– Current share price P0 = $100
– Expected dividend growth g = 4% (0.04)
RRR = 3/100 + 0.04 = 0.03 + 0.04 = 7%
When to use DDM
– Company pays relatively stable dividends.
– You are comfortable forecasting a steady long-term growth rate.
Limitations of DDM
– Not applicable for non-dividend-paying companies.
– Sensitive to the choice of g (small changes in g can produce large changes in RRR).
4. Step-by-step: calculating RRR with CAPM
Practical steps
1. Choose an appropriate risk-free rate (rf): typically the yield on government securities matching your investment horizon (e.g., 10-year U.S. Treasury yield for long-term equity investments).
2. Estimate beta (β): use a published beta (Bloomberg, Reuters, Yahoo Finance) or compute using historical returns regression against a market index.
3. Choose the expected market return (rm): a long-term historical average for the market (e.g., U.S. large-cap equities) or an investor’s estimate. The equity risk premium is (rm − rf).
4. Compute RRR = rf + β × (rm − rf).
5. Sensitivity: test results for different rf, β, and market-return assumptions.
Example
– Risk-free rate rf = 2%
– Market return rm = 10% → market risk premium rm − rf = 8%
– Company beta β = 1.5
RRR = 2% + 1.5 × 8% = 2% + 12% = 14%
Practical tips for CAPM inputs
– Risk-free rate: align term with investment horizon.
– Beta: be aware betas vary by data source, frequency, and estimation period; consider adjusting raw beta toward 1 (Blume adjustment) or using industry averages for new ventures.
– Market return: use long-term historical averages, but consider that expected future market returns may differ from history.
5. How to use RRR in practice
– Valuation: use RRR as the discount rate in DCF or dividend discount valuations (nominal RRR for nominal cash flows).
– Investment decision rule: accept a project or security if expected return ≥ RRR (for companies: accept projects with IRR > RRR/hurdle rate).
– Capital budgeting: set a hurdle rate that reflects company cost of capital plus project-specific risk premiums.
– Portfolio management: use RRR to compare expected returns across opportunities, adjusted for risk.
6. RRR versus cost of capital (WACC)
– WACC (weighted average cost of capital) is the firm’s overall cost of financing (debt and equity) and represents the minimum return a project must earn to cover financing costs.
– RRR is an investor’s required return for bearing investment risk; for project evaluation, firms typically use a hurdle rate that is equal to or higher than WACC (to provide a margin for risk or informational frictions).
– In practice: for a typical project, WACC is the baseline; higher-risk projects get a higher hurdle (RRR) above WACC.
7. Limitations and pitfalls of RRR
– Model risk: CAPM relies on single-factor beta; DDM assumes constant dividend growth—both are simplifications.
– Input sensitivity: small changes in growth or market premium assumptions materially change RRR and valuations.
– Subjectivity: investors’ risk tolerances, inflation expectations, and liquidity needs differ.
– Beta instability: historical beta may not reflect future systematic risk, especially for changing businesses or start-ups.
– Nonfinancial risks: regulatory, operational, and liquidity risks may require additional risk premia not captured by CAPM.
– Inflation and real vs nominal: be consistent—use nominal RRR with nominal cash flows, or adjust for inflation to get real RRR.
8. RRR vs Internal Rate of Return (IRR)
– IRR is the discount rate that makes the net present value (NPV) of a project equal to zero—an estimate of a project’s expected return based on its cash flows.
– RRR is the required threshold (hurdle) rate.
– Decision rule: accept project if IRR ≥ RRR (or equivalently NPV ≥ 0 when discounting at RRR).
– Differences: IRR can be misleading for nonconventional cash flows or mutually exclusive projects; RRR reflects external required compensation for risk.
9. Should RRR be high or low?
– It depends on risk: higher risk assets and projects should have higher RRRs; lower-risk assets (e.g., utilities, government bonds) require lower RRRs.
– For an individual investor, a higher personal risk tolerance may imply a lower personal RRR for a given asset, but market-implied RRRs depend on broader investor expectations.
10. What is a “good” return?
– “Good” is relative: it should exceed your RRR and other available alternatives after adjusting for risk, taxes, fees, and inflation.
– For context (U.S., historical):
• Long-run nominal equity returns have averaged roughly 7–10% annually (varies by period and index).
• Long-term real returns (after inflation) have been lower—often cited near 6–7% nominal or ~4–7% depending on the series and period.
– Use market benchmarks, historical premiums, and current yields to set realistic expectations.
11. Practical checklist when estimating and applying RRR
– Decide whether DDM or CAPM is more appropriate given the security (dividend-paying vs non-dividend).
– Select an appropriate risk-free rate (match horizon).
– Choose a defensible market return / equity risk premium (document the source).
– Estimate beta carefully (source, period, frequency) and consider adjustments.
– For DDM, justify the dividend growth rate; use multiple scenarios.
– Decide whether to use nominal or real rates; be consistent with cash flows.
– Test sensitivity of valuation and decisions to plausible ranges for RRR.
– For corporate projects, start with WACC and add project-specific premiums if needed.
– Revisit and update RRR assumptions periodically (market conditions change).
12. The bottom line
The required rate of return is a fundamental input in valuation and capital allocation. It is conceptually simple—compensate for risk—but practically difficult to estimate precisely because it depends on several judgment-based inputs. Use appropriate models (DDM for stable dividend payers, CAPM for market-based risk), document your assumptions, and always run sensitivity analyses. Treat RRR as a guide rather than an absolute single number.
Sources and further reading
– “Required Rate of Return (RRR),” Investopedia, Jessica Olah.
– For CAPM background and critiques: academic and practitioner sources such as Aswath Damodaran’s valuation resources (NYU Stern) and standard corporate finance texts.
Editor’s note: The following topics are reserved for upcoming updates and will be expanded with detailed examples and datasets.