The required rate of return is simply how much profit is necessary to pursue an investment. Corporate managers calculate the required rate of return for equipment purchases, stock market investments and potential mergers. However, the required rate of return can be calculated for personal investments also, such as investing in the stock market.
The Capital Asset Pricing Model, or CAPM, method is used to calculate the required rate of return. The CAPM method requires three pieces of information: the rate of return on a risk-free investment, the beta and the average market return. The following formula calculates the required rate of return: Rf + B(Rm – Rf). RRR stands for the required rate of return, Rf is the risk-free rate of return, B stands for beta (usually signified by the greek letter beta), and Rm refers to the average market return.
Find Risk-Free Rate of Return
Find the rate of return on a risk-free investment. Risk-free investments are "sure things." For example, if you put your money in a savings account earning 2 percent, you can be sure that the money, plus 2 percent, will still be there a year from now.
When determining the risk-free rate of return, find the highest return applicable to your situation. For example, if you plan on holding a stock for one year, a comparable risk-free return might be a one-year CD at your bank. When calculating the required rate of return, it is not necessary to convert percentages to decimals, so long as you're consistent.
Determine Average Market Return
The market return can be obtained from any financial publication that lists stock market indexes such as the Dow, S&P 500 or the NASDAQ Composite. Use the Dow or S&P 500 if you’re considering buying the stock of large, Fortune 500 company. The NASDAQ is a better index if you’re considering a technology stock or a smaller company.
Find Your Investment's Beta
The beta is a measurement of volatility compared to the market return. A beta of 1 indicates that the investment will move exactly as the market will, while a negative beta indicates that the investment moves in the opposite direction as the market. Finally, a beta of 0 indicates no correlation with the market return. Calculating the exact beta for your investment is usually not necessary, as many financial publications publish the betas of publicly traded stocks.
Calculate Required Rate of Return
Using the CAPM method, find out your rate of return. As an example, assume we are considering investing in 100 shares of IBM stock. Your bank’s rate for a one-year CD is 0.54 percent. Say the S&P for the past year was 5.46 percent. If IBM’s beta is 0.73, the required rate of return is: RRR = 0.54 + 0.73 (5.46 - 0.54) = 4.1 percent.
- When calculating the required rate of return, it is not necessary to convert percentages to decimals, so long as you're consistent.
Sara Huter is a professor of economics. Her background also includes risk management in the banking and energy industries with expertise in credit scores. Huter received an M.B.A. in finance from Texas A&M University and a B.S. in information systems from Kansas State University. She has been writing for over five years with work at Popsyndicate.com, WickedWordSmith.com and Simplejoy.com.