Investors expect to get paid for taking risks in the form of higher returns. Investments such as savings accounts have little uncertainty. Stocks, on the other hand, can potentially lose money as well as reward investors. An investment with a higher level of risk, such as an individual stock, has a higher potential return than a savings account because it may not meet expectations, while the savings account will.
How a Hurdle Rate Works
We begin building a hurdle rate with a risk-free rate of return. U.S. Treasury notes and bonds typically are used as a risk-free rate of return because there is virtually no chance the investment will fall short of expectations. Investments that have a return greater than the risk-free rate of return offer a “risk premium” to the investor. To calculate the hurdle rate, some investors add the risk premium and risk-free rate of return. Investors could use the historical risk premium of the S&P 500 rate of return in excess of the U.S. Treasury 10-year bond to calculate the risk premium. The average of the U.S. equity risk premium from 1926 to 2020 was 6.43% above risk-free return rates, based on the S&P 500’s historical risk premium. Based on the U.S. Treasury 10-year bond rate, the risk-free rate of return in the summer of 2021 was 1.33%. Therefore, the hurdle rate would be 7.56% x (6.43% + 1.33%). So, if you project that an investment can bring in 11% returns and the hurdle rate is 7.56%, you might consider the investment a good one because you may earn a return of more than 3% above the hurdle rate. The hurdle rate is often used as the discount rate for a net present value calculation, too. Here’s why that’s important: If you have an opportunity for a franchise, rental property, or your business, the net present value (NPV) is a standard financial measure that can be used to evaluate and compare investments based on their potential for cash flow. If you were considering buying a rental property here’s how you might look at it:
Purchase price: $250,000Projected 10-year rental income: $18,000 per yearDiscount rate: Hurdle rate of 7.56%Present value of $18,000 received for 10 years discounted at 7.56%: $123,216
The present value of the projected rental income at the hurdle rate is less than the initial investment of $250,000. If your goal is to break even after 10 years based on a 7.97% discount rate, this investment won’t do it.
Types of Hurdle Rates
There are several numbers investors may use to calculate the hurdle rate: cost of capital, historical equity risk premium, and implied equity risk premium.
Cost of Capital
Cost of capital has multiple definitions, but a popular one is the cost a business pays to raise funds. The funds can come from selling new shares (equity) or borrowing money (debt). Finance managers use the business’s cost of capital because the returns on any investments made should exceed the cost of funding it.
Historical Equity Risk Premium
The historical equity risk premium is the average difference between the returns on stocks (equity) and the risk-free rate, usually the three-month U.S. T-Bill, or 10-year bond rate over a period of years. The S&P 500 and other indexes are often used as a measure of equities.
Implied Equity Risk Premium
The implied equity risk premium is forward-looking instead of historical. It is calculated using analyst projections of growth and stock dividends. Firms like KPMG regularly publish their estimates of the implied equity risk premium.
What the Hurdle Rate Means to the Average Investor
Hurdle rates are used as a benchmark to evaluate investments. They can also be used as part of your retirement and financial planning process. Retirement and financial planning are about setting goals and developing a plan to meet them. How much you need to save and invest to meet those goals depends on future investment returns. For example, based on your current ability to save, you determine that you need a 6% investment rate of return after tax to meet your retirement-plan goals. While a model portfolio of 20% bonds and 80% stocks might perform at 6% based on historical returns, you are comfortable with more risk and base your plan on 10% bonds and 90% stocks. The higher 8% historical rate of return gives you the flexibility to put away less money, but also exposes you to a somewhat higher risk of loss. The converse of this is also possible using hurdle rate. Say you determine based on your income that you need a 12% investment rate of return to meet your retirement goals. Historical models show, however, that you would have to outperform the market to achieve your goals. You decide to revise your plan and extend your retirement age to reduce the hurdle rate you need.
