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How is a required rate of return determined? What methods are used to determine this rate? If you’re curious, this week’s blog takes a look at the most common methods used to determine the required rate of return for an equity investment in a particular business.
The required rate of return on equity (ROE) is meant to reflect the rate of return needed to compensate an equity investor for the risks assumed in making the investment relative to alternative investments available in the market. Generally speaking, the higher the perceived risk of an investment, the greater the return needed for accepting those risks. Understanding this concept is important as it is a fundamental investment principle.
The build-up approach and the capital asset pricing model are two of the most common methods used to determine the required ROE for an investment.
While a detailed description of these methods could fill an entire semester’s worth of finance studies, we hope this blog helps to give you a quick look into the world of ROE.
In a nutshell, both approaches start with a risk-free rate of return (generally regarded to be the interest rate on a long-term government bond), which is then adjusted for different elements of risk. For example, a risk premium would be added for each of the following elements:
The resulting estimate of ROE is then used in conjunction with the cost of debt to determine an overall weighted average cost of capital (WACC) – take a spin through last week’s blog to learn more about WACCY world of valuations.
The WACC is then applied to determine the present value of estimated future business cash flows in a valuation based on the Income Approach.
We hope you found this week’s post interesting. For more information about ROE or to recommend topics for future blogs we encourage you to contact us.