So Schweser had a question where they asked for the quick and easy way to arrive at an expected return on equity for a company with limited number of shares outstanding. The options were Multifactor, CAPM and build up. Now had they asked for the required return on equity, i would have chosen build up . The words expected return thew me. Since the answer was build up, am I too assume that required return on equity and expected return on equity are the same thing?
- Required return on equity is what the investor is expecting to receive for taking on this investment risk.
Hence you are right they are the same thing…just a play on words.
All of the three are good and valid ways to estimate the required return BUT since there are limited shares outstanding the only option that does not on the market portfolio too much and is more flexible and able to include size, specific company premium etc etc…is the build up method.
Hopefully this question isn’t too redicululously stupid.
I know you want your expected / predicted return to exceed your required return (or at least be equal), so tell me what i’m missing.
If your expected return is greater than you’re required return, than aren’t you discounting by a larger denominator, and therefore the stock price indicated will be lower than if you use the require return ?? And if you expected the market price to converge to your value, then wouldn’t the mkt price have to fall…how is that good?
Can someone clairfy why expected return > required return is best.
That hurts to ask.
Expected return and required return are only the same when ‘current price equals perceived value’. They shouldn’t necessarily be used interchangeably. If the current price is below perceived value then the expected return will be greater than required return if market price converges to perceived price. i.e. you get the required rate of return plus the mispricing between current price and perceived value.
The CFA text does state that the bond yield plus risk premium method (a form of the build up method), provides a quick estimate of the cost of equity. Probably as only the company’s long term debt and a risk premium is required. -> less inputs
Expected return and required return are only the same when ‘current price equals perceived value’. They shouldn’t necessarily be used interchangeably. If the current price is below perceived value then the expected return will be greater than required return if market price converges to perceived price. i.e. you get the required rate of return plus the mispricing between current price and perceived value.
The CFA text does state that the bond yield plus risk premium method (a form of the build up method), provides a quick estimate of the cost of equity. Probably as only the company’s long term debt and a risk premium is required. -> less inputs