Before investors commit their money to an investment a specific stock, they typically perform an equity valuation, assessing the current value of the asset or a company. The process of a valuation can take many forms and can entail many pieces, some of which you might already be familiar with. However, the piece of many valuations that will be the focus of this article is called the Required Rate of Return (RRR).
The RRR is a frequently used metric that shows the minimum annual percentage earned by an investment that will induce individuals or companies to put money into it. Basically, the RRR answers the question: what return from this investment do you have to make in one year for you to consider buying in today? For most of us, our next question would likely be about the risk of the investment in consideration, as taking on higher risk would be less appealing unless it could produce much higher returns. As you can see already, this metric can be extremely useful from the point of view of a single investor, as it helps them to consider investments based on their risk preferences.
To find the RRR, investors must consider the risk-free rate of return, the return on the market, and the volatility of the specific stock in question. But, before you think this calculation sounds like too much financial jargon for the average investor, allow us to explain.
Finding the risk-free rate of return is simple. All you need to do is look at a U.S. government security – the U.S. treasury bill – since it is generally considered to be risk free. For the sake of this example, let us assume that the risk-free rate is 3%.
Next, you simply need to find the return on the market, looking at a broader market that might capture a return that is close to the average return on as many stocks as possible. For this example, we can use the S&P 500, which has yielded an average of 10% returns since its inception in 1928.
Finally, the last piece of this equation is the stock’s measure of risk, sometimes called Beta. A beta for a company takes into account the history of the stock’s volatility compared to the volatility of the market as a whole. The market average (or average volatility) is a beta of 1.0. Then, stocks with beta values higher than 1.0 are said to have higher levels of volatility than the market average. Stocks with beta values lower than 1.0 are said to be less volatile than the market average, which effectively makes them less risky. For the purposes of calculating a stock’s RRR, investors can find the beta values for most listed stocks online. In this case, we can use the beta for Amazon, which is 1.72, meaning the stock has been slightly more volatile than the market average recently.
Now, we have all of the pieces we need to calculate Amazon’s RRR. The equation we use is the following:
RRR = Risk Free Rate + Beta (Return on the Market – Risk Free Rate)
Or, in this case, we would have:
RRR = 3 + 1.72 (10 – 3)
Simplified, this equation demonstrates that the RRR for Amazon is 15.04%. This number indicates the minimum rate of return that is sought by many investors and companies when they look to invest in Amazon currently. For many investors, it can be useful to compare Required Rates of Return between different investment opportunities, in order to align the rates of return for their investments with their own individual risk preferences. Ultimately, individuals with riskier investment strategies will likely consider investments with hither RRRs than individuals with lower risk preferences.