Required return on equity represents the rate of return a company needs to earn on specific projects. Equity is the external funds a company uses for major business operations. In most cases, investors who place equity funds into a business expect to earn a financial return. To the company, this expected financial return is the cost of capital related to the use equity funds. Therefore, a company’s required return on equity has to be higher than the cost of capital in order for the business to experience some level of success on the project.
Measuring a company’s required return on equity falls under the corporate finance or business analysis division. This department or group of individuals review costs related to equity funds and their use. All costs for each project must be separate as this allows for an easier measurement of the return on equity. In many cases, a company uses invested equity funds for multiple projects. That way, a project with a lower rate of return can be offset by projects with much higher rates of return.
The basic return on equity formula is net income divided by shareholder’s equity. While this is a company’s overall profitability measurement for equity funds, the corporate finance department can modify this formula to compute the required return on equity. For example, the formula can measure the difference between cash inflows and cash outflows divided by equity funds used. Each project uses this formula to ensure the rate of return is sufficient. The accounting department often has information the corporate finance department can use for this process.
A company’s owners, executives, or other management members often set the required rate of return for each project. The percentage that represents the rate of return often comes from a period of study. For example, an owner can review similar operations by competitors. Judging the success of competitors based on their financials can help set a company’s required return on equity. Other times, a company’s management team simply places a rate of return onto each project that will provide sufficient financial returns.
Individuals can also use the required return on equity investments. In most cases, this rate of return comes from the stock investments an individual purchases in an open exchange. The investor looks to make a specific rate of return from each stock purchase. These may be carefully calculated figures or arbitrary percentages selected by the investor. The formula is basically the same as it is for companies: returns earned divided by the cost of the investment.