Required Return on Equity

Sarah Martin

30 years: Corporate Valuations

In this video, Sarah explores the required return on equity, a crucial input into the weighted average cost of capital (WACC). She explains how this is typically estimated using the capital asset pricing model (CAPM), and breaks down its key components: the risk-free rate, the market risk premium, and beta. She also highlights some of the practical issues that arise when applying this model.

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Required Return on Equity

8 mins 38 secs

Key learning objectives:

Understand what is meant by the required return on equity
Learn how CAPM is used to estimate the return on equity
Understand the role of the risk-free rate, market risk premium, and beta
Identify the limitations and subjectivity in applying CAPM

Overview:

The required return on equity represents the return an investor expects for taking equity risk, and is a key component of WACC. As equity investors do not have a contractual claim to returns, this figure is subjective. The capital asset pricing model (CAPM) is a widely used tool for estimating it, combining the risk-free rate, market risk premium, and a company’s beta. Sarah explains each of these inputs, discusses how to deal with country-specific risks and limitations, and explores why CAPM remains a go-to method, despite its drawbacks.

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Summary

What is the required return on equity and why is it important?
The required return on equity is the return investors expect for taking the risk of owning shares in a firm. Unlike debt, equity doesn’t guarantee a return so it is subjective and plays a major role in valuation via the WACC. The term is often used interchangeably with cost of equity, but “required return on equity” is more accurate since equity investors aren’t promised a fixed return.

How do investors estimate the required return?
Some investors use heuristics or expectations based on past experience. Others, particularly in corporate finance, use models like the capital asset pricing model (CAPM) to make this more systematic.

What is the Capital Asset Pricing Model (CAPM)?
CAPM estimates the required return on equity by adding a risk premium to the risk-free rate. The formula is:

Required return = Risk-free rate + (Beta × Market risk premium)

What is the risk-free rate and how is it chosen?
This is the yield on a default-free bond, like a US Treasury or German Bund. If valuing a firm in a country with lower credit ratings, a sovereign spread is added to reflect added risk. For example, valuing a Spanish company in euros would involve adding the spread of Spanish government debt over German Bunds.

What is the market risk premium?
This is the excess return investors expect from the market over and above the risk-free rate. It is typically calculated using long-term historical returns of equity markets, but results can vary depending on whether geometric or arithmetic averages are used.

What is beta and what does it measure?
Beta measures a stock’s sensitivity to overall market movements. A beta above 1 means the stock is more volatile than the market; below 1 means less volatile. Beta increases or decreases the required return based on the level of risk.

For listed companies, beta can be sourced from platforms like Bloomberg or Yahoo Finance. However, betas under three years in length or affected by corporate events may be unreliable. Private company betas must be estimated based on industry comparables.

What are the limitations of CAPM?
CAPM can be distorted by unreliable beta estimates, limited or non-existent market return data (especially in emerging markets), and differing interpretations of risk. Additionally, some investors see high beta as signalling upside potential (not necessarily more risk).

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Sarah Martin

Sarah Martin has a degree in economics from the London School of Economics and stock exchange and regulatory qualifications from London and New York. She has worked in investment banking for 17 years, as well as private equity transactions and as an expert witness in financial trials. She became a financial trainer 15 years ago and specialises in credit, distressed debt, and valuation. Recent assignments have included the European Central Bank, the European Investment Bank, the EBRD, Gibbs Business School in Johannesburg, the Bahrain Institute of Business Finance, the Bank of China, BBVA, the African Development Bank, Siemens, Carnegie Bank, Rand Merchant Bank, the Hamburg Central Bank, and Mizuho Bank.

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