Required Rate of Return (RRR)

The required rate of return (RRR) is the minimum return an investor or firm expects to receive from an investment to compensate for its risk. It acts as a hurdle rate for investment decisions and equity valuation.

Key takeaways

• RRR is the minimum acceptable return given an investment’s risk.
• Common methods to estimate RRR are the Dividend Discount Model (DDM/Gordon Growth) and the Capital Asset Pricing Model (CAPM).
• RRR differs from cost of capital; RRR should exceed the cost of capital to justify taking on risk.
• RRR is subjective and depends on investor risk tolerance, inflation expectations, market alternatives, and liquidity.

What RRR tells you

RRR provides a benchmark to:
* Decide whether to buy a stock, accept a project, or compare investment opportunities.
* Incorporate a risk premium above a risk-free rate to reflect volatility and uncertainty.
* Compare required compensation for higher-risk investments (higher RRR) versus lower-risk ones (lower RRR).

How to calculate RRR

1) Dividend Discount Model (DDM / Gordon Growth)

Best for dividend-paying stocks with relatively stable dividend growth.

Formula:
RRR = (Expected dividend next period / Current share price) + Dividend growth rate
(or RRR = D1 / P0 + g)

Steps:
1. Estimate D1 = expected dividend next year.
2. Use current share price P0.
3. Estimate steady dividend growth rate g.
4. Compute RRR = D1/P0 + g.

Example:
If D1 = $3, P0 = $100, and g = 4%:
RRR = 3/100 + 0.04 = 0.07 or 7%.

2) Capital Asset Pricing Model (CAPM)

Common for stocks that don’t pay dividends or when using market-based risk measures.

Formula:
RRR = Risk-free rate + Beta × (Market return − Risk-free rate)
(or RRR = Rf + β(Rm − Rf))

Definitions:
* Rf = risk-free rate (e.g., short-term Treasury yield)
* β = beta of the asset (systematic risk relative to the market)
* Rm = expected market return

Steps:
1. Choose Rf (risk-free rate).
2. Estimate Rm (market expected return).
3. Obtain β for the security.
4. Compute equity risk premium = (Rm − Rf).
5. Multiply β by the equity risk premium and add Rf.

Example:
If Rf = 2%, Rm = 10%:
* Company A, β = 1.50 → RRR = 2% + 1.50 × (10% − 2%) = 14%
* Company B, β = 0.50 → RRR = 2% + 0.50 × (10% − 2%) = 6%

RRR vs. Cost of Capital

• Cost of capital is the minimum return required to cover the cost of financing (debt and equity) for a project and reflects the firm’s capital structure.
• RRR is the investor’s or decision-maker’s minimum acceptable return given risk.
• RRR should generally exceed the cost of capital to justify undertaking a project or investment.

Limitations

• Subjectivity: RRR depends on investor risk tolerance and expectations; different investors may use different RRRs.
• Inflation: Simple RRR calculations may omit explicit inflation adjustments; use real rates if needed.
• Liquidity: RRR typically doesn’t account for liquidity risk (illiquid investments may warrant higher required returns).
• Model assumptions: DDM assumes stable dividend growth; CAPM relies on a single beta and market-return assumptions.
• Cross-industry comparisons: Different industries have different risk profiles and betas, complicating direct comparisons.

Short FAQs

What’s the difference between IRR and RRR?
* Internal Rate of Return (IRR) is the discount rate that makes a project’s net present value zero. You pursue a project if IRR > RRR (the required/hurdle rate).

Should RRR be high or low?
* A higher RRR implies higher perceived risk; the appropriate level depends on the investment’s risk profile and investor preferences.

What is a “good” return?
* There’s no universal threshold, but a commonly cited benchmark is roughly 7% annually (inflation-adjusted long-term market return). Individual expectations and risk should guide decisions.

Bottom line

RRR is a practical benchmark for evaluating investments and projects. Use appropriate models (DDM for dividend stocks; CAPM for market-based assessments), adjust for inflation and liquidity where relevant, and remember that RRR is inherently subjective—best used alongside other metrics when making investment decisions.