Demystifying Required Return

Friday, August 13th, 2010

The required return for an investment is closely associated with the risk of the investment. The base return from which other returns are derived is the so-called “risk free” return, which is derived from the government bond yield. All other investment assets must deliver a higher return than government bonds. This is because all other investment assets implicitly have a higher risk profile than a government bond.

Investment assets should produce a higher return proportionate with their individual risk i.e a bank bill should produce a higher return than a bond. Equity should produce a higher return then a bank bill.

An investment in a company’s shares is a high risk proposition. This risk is measured or described as the equity risk premium. Equity risk may be expressed as the required return above the risk free return. There is significant research which suggests that the average equity risk premium for the whole market is 7%. Thus, if a ten year bond yields 5% then the average required return for an investment in a listed company is 12%. But this is an average and some companies may have a higher or lower required return.

So what should the required return be for an individual company?

At MyClime, we have undertaken extensive research, to identify the factors or “attributes” that determine the required return for an investment in a listed company.

These attributes are both external and internal to all companies. However, by consistently reviewing and applying these attributes across the MyClime universe we can derive a structured required return for individual companies. That is, companies with similar weighted average attributes will have a similar required return.

The required return will thus be the risk free return (+) the equity premium required return (+/-) the relative attributes of a company.

For those who prefer a more analytical approach the “required return” can be presented algebraically as:

Equation 1

The market equity required return (RRm) is based on the risk free rate, rf, equity risk premium (ERPm) in the market. Both can be measured and are observable.

The required return for the individual company (RRi) is a function of the discount or premium to the required equity risk return of the equity market. This can be expressed in a generic form as:

Equation 2

where “±” represents the discount or premium of all the external, internal parameters and the market capitalisation factor is relative to the market’s required return.

Factors used to calculate ri

The required return for individual stocks is dependant on three major factors. They are:

  1. External factors (or attributes) that will influence the profit or profitability of a company. These factors are generally beyond the control company management e.g. the exchange rate;
  2. Internal factors (or attributes) that will influence the profit or profitability of company management, e.g. gearing of a company;
  3. Market Capitalisation is related to the size and liquidity of the company. In general the market assesses a lower required return for larger companies.

1. External Factors

May include: The barrier to entry to the particular market in which the business operates The pricing power of the company against suppliers and/or clients The competitive landscape observed in the market considered in the context of its rivals The cyclicality of the business The susceptibility to technological changes or to currency or commodity values For every factor, we assign a degree of negativity or positivity. We then sum the influence of all these factors. At MyClime, we have a total of 12 external parameters which we believe are sufficiently important to be included in our analytical model.

2. Internal Factors

Internal forces that will influence the operational efficiency include: Competency of the management; Gearing in the balance sheet; Interest cover; Dividend (franked and unfranked; and The basis of the NTA or equity per share and particularly the level of intangibles For every internal factor, we again assign a degree of negativity or positivity. We then sum all of these factors together. MyClime has a total of 11 internal factors which we believe are sufficiently important to be included in our analytical model.

3. Market Capitalisation

Market liquidity or market capitalisation plays an important role in the market. Analytical research of historical market data has consistently shown that the market is willing to pay a premium for larger capitalisation stocks, while pricing smaller stocks (say) outside the ASX 200 at a discount. We consistently research in this area and have applied an appropriate discount / premium for individual stock depending on their inclusion into different indices in the market.

Putting it all together

Equation 2The numerical value for the external, internal and market capitalisation factors are weighted and summed. The end result is a numerical number for ri which represents the discount or premium to be used in Equation 2  to calculate the required return for the individual company.

If the final calculated ri is negative, it implies that the company is more attractive than the market average and thus more attractive than its peer companies on the ASX. Alternatively, if it is a positive (i.e. higher premium) then it is a relatively less attractive company than the market average.

In general, the required return will only change when the circumstances that govern these factors are altered. Normally, the specific or total required return of a company should only vary slowly and/or slightly over time. However, this is impacted by the bond market or risk free rate of return. As bonds are freely tradeable and observable it is likely that the risk free return will vary more frequently and could impact more regularly on the total required return of a company.

We are confident in our required return model because:

  • it is fundamentally based on observable factors;
  • the required return determined for each company is consistently applied; and
  • the model is reasonably flexible and additional factors may be added or the weightings of existing factors adjusted based on observation or changes in economic climate.

Thus one of our key tasks is not only to maintain the relativity, relevance and varying degree of emphasis for each of these parameters at all times, but also to be on a constant lookout for new structural shifts, or any precipitating factors in the local and global economy that may eventually show up to influence the required return.

 

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