Required rate of return (discount rate)

The required rate of return (discount rate) is used to value and compare different stocks. The required rate of return is the percentage return that one would expect from an investment based on its risk.

The required rate of return is composed of a risk free rate, a market risk and company specific risk that is calculated by the use of a beta value. The CAPM (Capital Asset Pricing Model) is often used to calculate the required rate of return.

Required rate of return = risk free rate + (market risk - the risk free rate) * beta

The required rate of return is used to discount future streams of cash flows from a share (dividend) or a company. A higher required rate of return reflects a higher risk and therefore provide a lower equity value or enterprise value.

Market risk is the risk associated with the entire stock market. If you diversify your stock portfolio completely by holding all shares in the market in their proportions, then you are only exposed to the market risk. The beta value of the market portfolio is 1. Market risk can not be avoided by diversification.

The risk free rate is obtained from the interest rate on treasury bills and government bonds. The risk free interest rate is the return that you can get without having to take any risk at all.

The beta value is the ratio of a stock's volatility to the volatility of the market portfolio. A beta value of 2 means that the stock has a volatility that is twice as high as the volatility of the market portfolio.
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