Investor's Required Return​

One of the components of your Required Return should reflect the return that is available from a risk-free investment. Investors will generally think of a risk-free return as being the return available from investing in long term government bonds (usually 10-year duration). These days there is an alternative to investing directly into government bonds which is afforded by low cost broad market index funds (ETF’s) which are listed on the stock exchange. This too could be seen as a good basis to decide what your discount rate will be, however at a higher risk than a government bond due to the fact that your return is not guaranteed.

Personally, I like to include a mix of inflation costs, long term government bond yields, and an equity risk premium. I will explain further in this chapter what each of these are and where you can find the data.

I would also like to note that the Discount Rate (Investors Required Return) is what we will be using to calculate a company’s Intrinsic Value. A Discount Rate is used to discount the projected future cash flow of the business to a present value. Basically, one way to calculate the Intrinsic Value of a company is to forecast future earnings for each year for the life of the business, then add these together to give us the Intrinsic Value of the business. But if we don’t discount those future earnings into the present value, the valuation will be grossly overpriced. As we know, due to inflation and other factors one dollar today does not buy you as much as it did 20 years ago.

For an example, let’s use a hypothetical company called ‘Leo’s Lemonade’. After the first year in business Leo produced $100 of free cash flow from selling his lemonade. Remember that free cash flow is the money that is left in the business after all expenses have been paid like taxes, wages, interest expenses, maintenance etc. Leo expects to grow his business and expand his free cash flow at a rate of 10% a year for the next 10 years when finally, the company will be sold as Leo has to move away to attend University. We will use a Discount Rate of 12% (you will see how to calculate the Discount Rate later in this chapter). Running these figures using a Discount Cash Flow (DCF) valuation method, we believe that when Leo sells his business in ten years’ time his business will be worth about $1,750. But that is the value of the business in 10 years’ time, so to express that into today’s dollars we will need to discount that valuation using the 12% Discount Rate. This gives the business a current Intrinsic Value of about $900. 

Summarised below is an overview of the three main components used in establishing the Investor’s Required Return (Discount Rate).

Inflation is basically the rate at which the value of your cash is decreasing each year due to the costs of goods rising (loss of purchasing power). The Investor’s Required Return should take into account expectations of inflation, which has averaged 3% per annum over several hundred years. At the conservative end an inflation rate of 5% would be appropriate. It is important to include inflation in your discount rate as not to do so would mean that the calculated future returns would be overstated when expressed in today’s dollars.

This link will take you to the International Monetary Fund website which has historical inflation data for each country.

You can view and download historical inflation rates from our website HERE

The Investors Required Return (Discount Rate) should also take into account a compensation for risk, or an ‘Equity Risk Premium’. The Equity Risk Premium is the difference between what you expect to receive on your investment compared to a long term ‘no risk’ government bond. To obtain the equity risk premium you simply calculate the expected return on an investment, minus the risk-free rate, usually a government bond. This figure is included in your Discount Rate to ensure that the price you pay can be expected to exceed the returns you would have otherwise achieved from a risk-free bond. The market’s Equity Risk Premium over the last few decades has ranged between 4% and 6% per annum.

You can calculate it for each individual company, as not all companies carry the same level of risk. Otherwise this site (Click Here) is a helpful tool to use when deciding on an appropriate Equity Risk Premium. The site uses the current equity market return as a whole and deducts the current risk free rate from that. This is the site that I use to establish the current Equity Risk Premium for my calculations.

In case the link didn’t work copy the site address below.

http://www.market-risk-premia.com/market-risk-premia.html

The risk-free rate is accepted as being the current yield of a long-term government bond, generally of 10 years or longer duration. Value Investors deem this as the highest risk-free return that you could receive from an investment. That is why it is used in calculating your Discount Rate, for it wouldn’t make any sense to invest in a high-risk investment like the stock market, if you didn’t take into consideration other returns that are available to you that have next to no risk. The reason it is deemed ‘Risk Free’ is because it is backed by government, so the chances of the government defaulting and not repaying your investment is slight, although not unheard of.

You can view and download historical risk-free rates from our website HERE

We now understand the importance of calculating the Investor’s Required Return, to help mitigate the risk of equity investing. By including Inflation we cover the losses inevitably incurred by the continuing rise in the price of goods (loss of purchasing power); having an Equity Risk Premium insures that we will only take on those investments that can achieve high enough returns to compensate for the risk of equity investments and finally, the Risk Free Rate will ensure that we include, as a component of the Investor’s Required Return, a return that is available from a ‘risk free’ investment which is usually represented by the yield from a 10 year government bond.

Basically, our Discount Rate is the sum of these three figures, Inflation, Equity Risk Premium, and the Risk-Free Rate. So, let’s take the long-term average Inflation of 3%, and say an Equity Risk Premium of 6% plus the current 3% yield on the government bond and we get a Discount Rate of 12%.

Discount Rate = Inflation + Equity Risk Premium + Risk Free Rate
   = 3% + 6% + 3%
   = 12%