The Practical Value of Knowing Required Returns

Abstract

An investor who knows the required return will know the discount rate that determines present value, and will know the "equilibrium" return that may help forecast future cash flows. Thus managers, scholars and students expend considerable effort estimating required returns. Curiously, the value of this knowledge has never been measured. Simulating the investor's decision reveals that a crude fixed investment hurdle delivers more than 99% of the theoretical maximum expected present value that could be obtained with perfect knowledge of required returns. This surprising result can also be demonstrated with a simple experiment using CRSP returns, and seems to hold in almost any plausible investment scenario. Knowing required returns is nearly valueless for two slightly subtle reasons: because the hurdle rate's required precision varies inversely with the expected abnormal return, and because exploiting the forecasting power of the equilibrium return (or its proxy, Beta) results in moving the predicted return closer to the hurdle, which cannot change the accept/reject decision. Thus a crude fixed investment hurdle is nearly optimal, and the formulation, testing, estimation and teaching of required return models such as the CAPM and APT, as well as more detailed refinement of cost-of-capital estimation, seems to have little prospect of materially improving investment decisions.

JEL Classification: G12, G31