Required rate of return is the minimum return an investor demands for accepting investment risk. In equity valuation, it can act as the hurdle used to assess expected returns or as the rate applied to future shareholder cash flows. With the cash-flow forecast unchanged, a higher required return produces a lower present value.
Required Rate of Return Formula
A general required-return estimate starts with a risk-free rate and adds a premium for the risk being accepted.
Required return = Risk-free rate + Required risk premium
For common equity, CAPM is one way to estimate the required return. Its risk adjustment uses beta, which represents exposure to broad market movements, and an assumed equity risk premium.
CAPM required equity return = Risk-free rate + Beta × Equity risk premium
The CAPM result is a model-based cost of equity. It depends on the selected risk-free rate, beta, and equity risk premium. An investor may use a different hurdle if the model does not adequately represent the risks or opportunity costs considered in the analysis.
Worked Example: CAPM and Present Value
Assume a risk-free rate of 4.0%, beta of 1.20, and an equity risk premium of 5.0%. The implied required equity return is:
4.0% + (1.20 × 5.0%) = 10.0%
To isolate the effect of the rate, assume a single $100 payment to an equity investor at the end of Year 10. Discount that same payment at 8%, 10%, and 12%.
| Discount rate | Present-value calculation | Present value today |
|---|---|---|
| 8% | $100 ÷ 1.0810 | $46.32 |
| 10% | $100 ÷ 1.1010 | $38.55 |
| 12% | $100 ÷ 1.1210 | $32.20 |
The payment and timing are identical in all three cases. The $14.12 difference between the 8% and 12% results comes entirely from the discount rate. This is a single-payment illustration of discounting, not a complete stock valuation.
Free cash flow to equity (FCFE) belongs to common shareholders. Discount it using a corresponding required equity return, or cost of equity.
Free cash flow to the firm (FCFF) is available to capital providers collectively. Discount it using a corresponding weighted average cost of capital (WACC).
Required Return, Expected Return, and Valuation
Required return is the hurdle set before evaluating an investment. Expected return is the result an analyst estimates from the price paid and prospective cash flows. An internal rate of return (IRR) can express the return implied by a modeled series of payments. Comparing an estimated return with a required return helps test whether the assumptions support the proposed price.
Long-duration valuations are particularly sensitive to discounting. In a perpetual-growth calculation, a required return close to the terminal growth rate can make the estimated terminal value highly sensitive to small input changes. The rate and growth assumptions need to be checked together.
CFA Institute’s Free Cash Flow Valuation reading distinguishes FCFE discounted at the required equity return from FCFF discounted at WACC. Wall Street Prep sets out the CAPM cost-of-equity formula using the risk-free rate, beta, and equity risk premium.
Beta measures market-related risk under CAPM; it cannot capture every business-specific concern. Forecast cash flows, leverage, customer concentration, and the selected risk premium may still be uncertain. Two investors can reasonably use different required returns for the same company because their models and opportunity costs differ. A required-return estimate may inform a margin of safety analysis, but it does not establish the value estimate or guarantee the realized return.
Related Valuation Concepts
See how the Capital Asset Pricing Model combines beta, the risk-free rate, and the equity risk premium.
See how a Discount rate converts future cash flows into present value and why the measurement basis matters.
Review market capitalization as the quoted value of common equity, rather than a model-derived valuation.