One of the most important topics in finance is the concept of expected return. This is the total return that an investor expects to earn from an investment within a year. Before making an investment, it is important for an investor to create a reasonable level of expectation, according to his or her investment policy statement. Expected return typically fluctuates according to an investor’s level of risk taking.
There are several ways for investors to measure expected return from a given security. This article will address some of the most common methods for calculating expected return, and why it is an important topic in finance.
What Is Expected Return?
In finance, expected return is what the investor expects to gain from an investment. It is based on the potential outcome from an investment and the probability that the potential outcome will be realized. For example, if a person bought a stock with a 50% chance of returning a positive 25%, and a 50% chance of delivering a 10% loss, the expected return of this particular investment would be 7.5%.
The equation is as follows:
In this sense, the expected return is a weighted average.
Investors should note that, like most other valuation metrics in finance, there are assumptions being made. The investor is assuming what the potential outcomes are. While these figures are typically based on historical data, they are nevertheless not guaranteed to occur exactly as anticipated. As a result, it is critical for the investor to use reasonable, realistic assumptions to try to create a reliable model.
Perhaps the most frequently utilized measures of expected return is the Capital Allocation Pricing Model, otherwise known as CAPM. This calculation determines the return an investor can expect from a stock. The CAPM equation takes into account a market risk premium, which is the expected return from a particular stock above the market return, factoring in the risk-free rate and a stock’s beta value. CAPM is also referred to as the cost of equity.
Discounted Cash Flow Equation
Discounted cash flow is arguably the most utilized method of performing valuation on a stock. It calculates the current and future cash flows projected for a business, then discounts these cash flows back to the present using a discount rate, which is the expected return. Discounted cash flow gives an investor an idea of the intrinsic value of a stock.
This formula can be rearranged to arrive at the expected return:
Bond Yield Plus Risk Premium
A similar metric is referred to as the Bond Yield Plus Risk Premium. This is another method used to calculate the cost of equity. The Bond Yield Plus Risk Premium equation is simply the yield on a company’s debt plus a risk premium.
Bond Yield Plus Risk Premium Formula:
The biggest risks for fixed-income securities are default risk and interest rate risk. In general, bonds are less risky than equities, but typically the cost of these sources move in tandem. This approach assumes that the spread between a company’s bond yield and its required rate of return is constant.
The Bottom Line
It is important to relate the concept of expected return back to the individual investor. The connection between an expected return and the investor is clear. Each investor should have their own level of risk aversion and expected return within the bounds of an investment policy statement. Measuring expected return given a certain level of risk is a good way for investors to more clearly articulate what they expect from an investment. To find out more on the topic of return for a given level of risk, please refer to How to Measure Risk-Adjusted Returns.