How to Determine the Required Rate of Return for Equity

The required rate of return on equity measures the return necessary to compensate investors for their investment risk. The higher the risk, the greater the required return on equity. You need to know the company's beta -- a measure of how the stock moves relative to the market -- its risk-free rate and the expected return for the broader stock market to calculate the required rate of return on equity. A stock with a beta of 1 rises $1 for every $1 the market increases; 2 means it increases $2 for every $1 the market increases and falls $2 for every $1 the market falls.

Step 1

Subtract the risk-free rate from the market rate. The risk-free rate is the return on theoretically risk-free investments like U.S. Treasury bonds. For example, if the market is returning 7.5 percent and Treasuries are paying 3 percent, the market premium is 4.5 percent.

Step 2

Multiply the risk-free rate by the stock's beta to find the market risk premium. In this example, if the stock has a beta of 1.2, multiply 4.5 percent by 1.2 to get the market risk premium of 5.4 percent.

Step 3

Add the market risk premium to the risk-free rate to find the required return on equity. In this example, add the risk-free rate of 3 percent to the market risk premium of 5.4 percent to find the required rate of return -- in this case, 8.4 percent.

Photo Credits

  • Hemera Technologies/PhotoObjects.net/Getty Images

Zacks Investment Research

is an A+ Rated BBB

Accredited Business.