When we value stocks, merely looking at the current profitability is insufficient. We also need to consider the risk involved when investing in a particular company.
In other words, we need to establish what minimum rate of return that we, as an investor requires, to hold shares in a business. This is known as the required return (RR).
A share is a high risk asset as it cannot be redeemed. To compensate an investor for the higher risk, the returns from a share investment must be substantially higher than a government bond or a bank term deposit.
The required return for an investment is closely associated with the risk of the investment. Risk is not measured by price volatility. Indeed price volatility gives an investor his opportunity. Risk is best thought of by asking a question: When investing this capital, will I preserve my purchasing power and achieve a sound additional return? The real risk when investing comes from misjudging intrinsic value, business quality, inflation and tax rates.
Factors used to calculate the RR for individual stocks is dependent on three major factors. They are:
- Internal company specific risks – this is calculated based on the quality of a company’s balance sheet using our proprietary Clime Quality Rating (CQR) measurement;
- External factors – this is determined based on the industry and sector of the company; and;
- Other factors relating to the company’s market capitalisation and whether they are a relative ‘newcomer’ to the market.
Calculating Required Return
To calculate the required return of an investment, we take:
An average risk free rate of government bonds
an additional equity risk premium for investing in the stock market (that is, a dollar invested in the stock market has greater risk and volatility than in a long term bond)
A company specific rate of risk
For those who prefer a more analytical approach the “required return” can be presented algebraically as:
Required Return =
(Risk Free Rate + Equity Risk Premium + Company Specific premium or discount)
Definitions in the above calculations:
- The risk free rate: As an investor to take their capital out of the safety of a bond to buy part of a business, we must demand a higher return then the risk free rate (defined as the 10 year Government Bond yield);
- The risk free return is added to the equity risk premium: This premium is observable over time and it is the difference between the long bond yield and the equity market total returns. Equity investments are unsecured and have averaged between 5 – 6% above the long term bond yield for over a century in Australia.
- Then a further risk margin is added based on company specific risk factors: Investing in any particular business entails a large array of variables about the sustainably of the business performance and occasionally its industry. We consider that there are at least 20 variables that lead to our company specific required return component.
In our view, the minimum required return for Australian equities is 11%. This rate applies to the strongest, highest quality companies with wonderful histories and prospects. The RR is made up of the risk free rate (currently 4.25%) and an equity risk premium (on average 6%) and the company specific return component. For companies of poorer quality or short histories, the chances of disappointment are higher and the required returns are up to 16%+.
Our analysts 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 analysts’ universe (watchlist), we can derive a structured required return for individual companies. That is, companies with similar weighted average attributes will have a similar required return.
To help you identify the risk of an investment, the investment team have grouped companies together that have a similar RR. There are four risk categories and each category represents the following ranges:
- Low Required Return = RR < 14%
- Moderate Required Return = 14% < RR < 16%
- High Required Return = RR > 16%
- Not Covered = Businesses which we do not provide valuations or qualitative insights for have been classified as Not Covered. This includes sub-investment grade businesses and Listed Investment Companies.
Find out the required return of your stocks of interest
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The hard work is all done for you. Brought to you by Clime and Alan Kohler’s Eureka Report, StocksInValue is an online stock valuation & research platform which provides you with the required return of listed companies. Not only will you have stock valuations for your company on interest, you will also gain access to our analysts’ commentaries and company insights to accompany those valuations to help you make smarter investment decisions.
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