How the required rate of return is used in valuation
In valuation, the required rate of return is used to discount future cash flows to a present value. The higher the requirement, the lower the valuation today.
The required rate of return reflects both company-specific risk and market conditions. It therefore directly affects pricing in investments, share issues and acquisitions.
Factors that affect the required rate of return
The required rate of return is set on the basis of several interacting factors.
- The company's maturity and track record
- The level of risk in the business model and market
- Liquidity and exit opportunities
- Capital structure and financial stability
- The investor's risk appetite and alternatives
Weighing these factors together determines what return is needed for the investment to be justified.
Why the required rate of return drives investment decisions
Worth bearing in mind
The required rate of return is central because it determines which investments are considered worth making. If the expected return does not exceed the requirement, the investor usually chooses not to invest.
In unlisted companies, required rates of return are generally higher than on the stock exchange. Lower liquidity, greater uncertainty and a longer time to exit mean that investors demand higher compensation for the risk.
Frequently asked questions
What is the difference between the required rate of return and the risk premium?
The risk premium is part of the required rate of return and reflects compensation for risk over and above the risk-free return.
Is the required rate of return the same for all investors?
No, it varies depending on risk appetite, strategy and investment horizon.
Why is the required rate of return higher in unlisted companies?
Because of higher risk, lower liquidity and a longer time to exit.
Can the required rate of return change over time?
Yes, as the company develops and the risk decreases, the requirement can be adjusted.
How does the required rate of return affect valuation?
A higher required rate of return leads to a lower valuation, and vice versa.