Stock Investing 101 – Required Rate of Return

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Required Rate of Return

This is the minimum rate of return needed from an investment before an investor would consider investing in it.

For example, if you have some money to invest but is currently servicing a mortage with an interest rate of 5%, your required rate of return from any investment you make will be 5%.

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What Is Rate of Return and What Is a Good Rate of Return?

Nov 13, 2020 5:34 PM EST

When you invest your money, the goal is to earn a good rate of return. But exactly what is a rate of return?

What Is Rate of Return?

As the name suggests, the rate of return is the percentage increase or decrease over your initial investment. It represents what you’ve earned or lost on that investment. The formula is:

Rate of Return = (New Value of Investment – Old Value of Investment) x 100% / Old Value of Investment

When you calculate your rate of return for any investment, whether it’s a CD, bond or preferred stock, you’re calculating the percent change from the start of your investment until the end of the period you’re measuring.

To do that, as shown in the formula above, let’s say you invested $1,000 in a company’s common stock two years ago, and now the value of your stock is $3,000. Subtract the old value from the new, which gives you $2,000, then divide that by the absolute value of $1,000 (the amount originally invested.) Multiply the answer by 100%.

Example of Rate of Return Formula

To illustrate this example:

1. Subtract current balance from original investment:

$3,000 – $1,000 = $2,000

2. Divide difference by the absolute value of original investment:

3. Multiply the quotient by 100% to turn it into a percentage:

2 x 100% = 200% Rate of Return

Interpreting Rate of Return Formula

If the old or starting value is lower, then you have a positive rate of return – a percent increase in value. If the starting value was higher, then you have a negative rate of return, or a percent decrease in value.

On the lower-risk end of the spectrum, savings and money market accounts can offer fixed rates of return. Fixed rate means that the rate will not change over time. The opposite of that is a variable rate, which is an interest rate that changes depending on how much interest rates rise or fall in the open market. Some Certificates of Deposit (CDs) offer fixed rates.

If you invest $1,000 in a one-year CD at a 2% interest rate, you already know what your rate of return will be – 2% – in exchange for letting the bank keep your money for a whole year. If you were to withdraw your money before the year was up, you’d be penalized for early withdrawal, and that would reduce your rate of return.

Assuming you keep the money invested in the CD in for the entire year, you’d calculate your gain at the end of it by taking the amount of your initial investment: $1,000 and multiplying it by the 2% rate of return in decimal form: .02.

How to Calculate Rates of Return for Different Investments

1. Bond Rates of Return

A bond’s return on investment or rate of return is also known as its yield. There are several different types of yield calculations. The most comprehensive is the total return because it factors in moves in the bond price, fees, compound interest and inflation.

To calculate a bond’s total rate of return, take the bond’s value at maturity or when you sold it. Add to that all coupon earnings and compound interest, and subtract taxes and fees. Then, subtract the amount of money you originally invested for the total gain or loss on the investment. Divide by the old value of the bond and multiply by 100%.

To simplify, if you bought a 4% coupon bond above par for 101, or $1,010, which pays $40.40 annually in interest, and then you sold it at par for $1,000 after having made $80.80 in interest, your rate of return would be about 7%.

(New Bond Value $1,000 + Coupon Interest $80.80 – Old Bond Value $1,010)/ ($1,010 Old Bond Value) x 100%

The bond’s rate of return is roughly 7%.

In a total return calculation, the compound interest, taxes and fees would have been factored in.

To find the “real return” – or the rate of return after inflation – just subtract the inflation rate from the rate of return. So if the inflation rate was 1% in a year with a 7% return, then the real rate of return is 6%, while the nominal rate of return is 7%.

2. Stock Rates of Return

When you buy stock, you’re buying a small piece of ownership in a company. Shares of stock have prices that rise and fall in a marketplace depending on factors like the company’s quarterly earnings and external conditions like interest rates and the economy. Some companies pay a quarterly dividend to share their earnings with shareholders.

To calculate the rate of return for a dividend-paying stock you bought 3 years ago at $100, you subtract it from the current $175 value of the stock and add in the $25 in dividends you’ve earned over the 3-year period. That gives you:

$175 new stock value – $100 old stock value = $75 gain

$75 gain + $25 dividends = $100 total per-share gains

$100 per-share gain / $100 per-share cost X 100% = 100% rate of return per share

Keep in mind that people usually purchase stocks through their brokerage accounts or vehicles like an Individual Retirement Account (IRA) or a 401(k) plan, which often charge fees that may alter the rate of return somewhat.

3. Real Estate Rates of Return

The rate of return for real estate purchases have a lot of costs to factor in, including interest rates paid on a mortgage loan. To get a rate of return on the sale of your home, take the sale price – say $580,000 after deducting closing costs, capital gains taxes and the cost of improvements you made to the home – and subtract the original purchase price you paid for home plus closing costs, about $500,000

(($580,000 – $500,000) / $500,000) x 100 percent = 16% Rate of Return

There is a plethora of other investment types, but you get the general idea for calculating a rate of return – new value minus old value, adjust for fees and income, divide by old value, multiply by 100%.

What’s Considered a Good Rate of Return?

Now that you know how to figure out the rates of return on the most common investment types, how do you know whether your investment’s return is good or not? What is a good rate of return?

Generally speaking, investors who are willing to take on more risk are usually rewarded with higher returns. Stocks are among the riskiest investments because there’s no guarantee a company will continue to be viable. Even huge corporations could fail from one day to the next and leave investors with nothing.

One way to minimize risk is to invest in a variety of companies in different sectors and asset classes (ie: stable value funds, bonds, real estate and stocks) over a long period of time. That may not lead to the 15%-35% returns you’re dreaming of, but diversification can spare you from a market crash wiping out your life savings. Investors who have remained invested in the S&P 500 index stocks have earned about 7% on average over time, adjusted for inflation.

The key to the S&P’s growth has been time – staying invested through low points until there’s an upturn. There have been long periods of growth when the index’s returns were heady, followed by bear markets with deep losses. The 90-year inflation-adjusted 7% rate of return is an average of some high peaks and deep troughs. Some stock market sell-offs have lasted for many years. For instance, the dot-com bubble burst in 2000 and by some measures has taken 17 years to recover.

Many stock investors are looking for the next Apple (AAPL) – Get Report or Amazon (AMZN) – Get Report in their zeal to beat the broad benchmark’s yearly average.

Saving for retirement is a daunting goal, and those who started a little late may chase yields that make them susceptible to fraud and Ponzi schemes. The rule of thumb for investing, as for most things – is that if it seems too good to be true, it probably is. If a fund or money manager guarantees 15%+ yearly returns, be skeptical. There is practically no way anyone can guarantee returns that high every year.

Among top five fund managers of all time, four were value investors who consistently beat the market and did so by ignoring hype and investing in undervalued stocks with strong fundamentals and low price-to-earnings ratios. If you want to beat the market during downturns, there’s a good chance you can do it by investing in a value fund or by being a value investor. Note, however, that value funds tend to under perform when the market is hot.

Bonds and Rate of Return

Bonds are known to be less risky than stocks, but there are certain classes of bonds that can be just as risky or riskier than equities. Luring investors with double-digit coupons, high-yield corporate borrowers with less than stellar credit hope to borrow some more and have to pay up to attract investors. Sometimes, the prospects of their ever being able to repay it are slim. Yields here can be high single digit to mid-double digit.

Countries like Argentina, Venezuela and Ecuador have offered sovereign debt with exorbitant yields because there’s a pretty good chance they won’t pay their debt either.

The U.S. credit crisis was caused by mortgage-backed securities, which are bonds backed by mortgages. They nearly collapsed our financial system. Bottom line is, don’t assume that because it’s a bond, it’s safe.

The safest bonds have traditionally been U.S. Treasurys. As inflation and interest rates have risen, so have Treasury yields. They’re considered safe because they’re backed by the full faith and credit of the U.S. government. Compared with other sovereign debt, U.S. Treasury yields are low – around 3% – because it is considered a haven.

Bonds are currently facing interest rate risk as the U.S. Federal Reserve has said it plans more interest rate hikes. Bond prices fall as rates rise because rates and bond prices have an inverse relationship. Long-term bonds have greater interest rate risk than those with similar creditworthiness and shorter maturities because with long bonds, there’s more time for rates to rise higher.

Investment-grade debt is somewhere in between Treasurys and high yield debt, and often offers the security of repayment guarantees, which stocks don’t have. Yields for investment grade bonds are about 100 basis points to 300 basis points below those of their high-yield counterparts. A basis point is a hundredth of one percent. Even the most rock-solid borrowers’ bond prices have been hit by rising interest rates, however, which is a risk that could last some time after the Fed’s nearly decade-long zero interest rate policy (ZIRP).

Which Portfolio Maximizes Returns?

A portfolio that’s 100% invested in stocks has historically had the highest returns compared with various other asset allocations of stocks and bonds, at about a 10% nominal return.

The only other asset that has matched stocks’ historically high returns as been residential real estate – including both housing prices and rental income.

Meanwhile, portfolio models that contained a larger share of stocks have historically outperformed those with heavier bond weightings, with all-bond portfolios showing the lowest average annual return at nearly half that of all-stock portfolios.

Typically, people who are closer to retirement age tend to be risk-averse and look for saver investments. Younger investors tend to take more risks because they have time to make up for big losses.

Target date mutual funds or ETFs take into consideration how long a person has before retirement and invests in a variety of securities that adjust over time to that investor’s needs. One complaint about these funds is that they may have higher fees given the greater variety of investments. They may not make the most of market moves, either.

As with any investment, it pays to stay informed and keep track of your holdings’ performance, keeping in mind that the most successful investors have stayed invested long term and avoided knee-jerk reactions to market moves.

Calculating Required Rate of Return – RRR

What Is Required Rate of Return – RRR?

The required rate of return (RRR) is the minimum amount of profit (return) an investor will receive for assuming the risk of investing in a stock or another type of security. RRR also can be used to calculate how profitable a project might be relative to the cost of funding the project. RRR signals the level of risk that’s involved in committing to a given investment or project. The greater the return, the greater the level of risk. A lesser return generally means that there is less risk. RRR is commonly used in corporate finance and when valuing equities (stocks). You may use RRR to calculate your potential return on investment (ROI).

When looking at an RRR, it is important to remember that it does not factor in inflation. Also, keep in mind that the required rate of return can vary among investors depending on their tolerance for risk.

Required Rate Of Return

What RRR Considers

To calculate the required rate of return, you must look at factors such as the return of the market as a whole, the rate you could get if you took on no risk (risk-free rate of return), and the volatility of a stock (or overall cost of funding a project).

The required rate of return is a difficult metric to pinpoint because individuals who perform the analysis will have different estimates and preferences. The risk-return preferences, inflation expectations, and a firm’s capital structure all play a role in determining the required rate. Each of these, among other factors, can have major effects on an asset’s intrinsic value. As with many things, practice makes perfect. As you refine your preferences and dial in estimates, your investment decisions will become dramatically more predictable.

Discounting Models

One important use of the required rate of return is in discounting most types of cash flow models and some relative-value techniques. Discounting different types of the cash flow will use slightly different rates with the same intention—to find the net present value (NPV).

Common uses of the required rate of return include:

  • Calculating the present value of dividend income for the purpose of evaluating stock prices
  • Calculating the present value of free cash flow to equity
  • Calculating the present value of operating free cash flow

Analysts make equity, debt, and corporate expansion decisions by placing a value on the periodic cash received and measuring it against the cash paid. The goal is to receive more than you paid. Corporate finance focuses on how much profit you make (the return) compared to how much you paid to fund a project. Equity investing focuses on the return compared to the amount of risk you took in making the investment.

Equity and Debt

Equity investing uses the required rate of return in various calculations. For example, the dividend discount model uses the RRR to discount the periodic payments and calculate the value of the stock. You may find the required rate of return by using the capital asset pricing model (CAPM).

The CAPM requires that you find certain inputs including:

  • The risk-free rate (RFR)
  • The stock’s beta
  • The expected market return

Start with an estimate of the risk-free rate. You could use the yield to maturity (YTM) of a 10-year Treasury bill—let’s say it’s 4%. Next, take the expected market risk premium for the stock, which can have a wide range of estimates.

For example, it could range between 3% and 9%, based on factors such as business risk, liquidity risk, and financial risk. Or, you can derive it from historical yearly market returns. For illustrative purposes, we’ll use 6% rather than any of the extreme values. Often, the market return will be estimated by a brokerage firm, and you can subtract the risk-free rate.

Or, you can use the beta of the stock. The beta for a stock can be found on most investment websites.

To calculate beta manually, use the following regression model:

βstock is the beta coefficient for the stock. This means it is the covariance between the stock and the market, divided by the variance of the market. We will assume that the beta is 1.25.

Rmarket is the return expected from the market. For example, the return of the S&P 500 can be used for all stocks that trade, and even some stocks not on the index, but related to businesses that are.

Now, we put together these three numbers using the CAPM:

Dividend Discount Approach

Another approach is the dividend-discount model, also known as the Gordon growth model (GGM). This model determines a stock’s intrinsic value based on dividend growth at a constant rate. By finding the current stock price, the dividend payment, and an estimate of the growth rate for dividends, you can rearrange the formula into:

Importantly, there need to be some assumptions, in particular the continued growth of the dividend at a constant rate. So, this calculation only works with companies that have stable dividend-per-share growth rates.

RRR in Corporate Finance

Investment decisions are not limited to stocks. In corporate finance, whenever a company invests in an expansion or marketing campaign, an analyst can look at the minimum return these expenditures demand relative to the degree of risk the firm expended. If a current project provides a lower return than other potential projects, the project will not go forward. Many factors—including risk, time frame, and available resources—go into deciding whether to forge ahead with a project. Typically though, the required rate of return is the pivotal factor when deciding between multiple investments.

In corporate finance, when looking at an investment decision, the overall required rate of return will be the weighted average cost of capital (WACC).

Capital Structure

Weighted Average Cost of Capital

The weighted average cost of capital (WACC) is the cost of financing new projects based on how a company is structured. If a company is 100% debt financed, then you would use the interest on the issued debt and adjust for taxes—as interest is tax deductible—to determine the cost. In reality, a corporation is much more complex.

The True Cost of Capital

Finding the true cost of capital requires a calculation based on a number of sources. Some would even argue that, under certain assumptions, the capital structure is irrelevant, as outlined in the Modigliani-Miller theorem. According to this theory, a firm’s market value is calculated using its earning power and the risk of its underlying assets. It also assumes that the firm is separate from the way it finances investments or distributes dividends.

To calculate WACC, take the weight of the financing source and multiply it by the corresponding cost. However, there is one exception: Multiply the debt portion by one minus the tax rate, then add the totals. The equation is:

When dealing with corporate decisions to expand or take on new projects, the required rate of return is used as a benchmark of minimum acceptable return, given the cost and returns of other available investment opportunities.

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