According to this approach, the past returns on a security are taken as a proxy for the return required in the future by the investors. The assumptions behind this approach are that
- The actual returns have been in line with the expected returns
- The investors will continue to have the same expectations from the security.
As these assumptions generally do not hold well in real life, the results of this approach are normally taken as a starting point for the estimation of the required return. The realized return over a n-year period is calculated as (W X W2 X…..Wn) 1/ n – 1, where, Wt, referred to as wealth ratio, is calculated as
Dt = Dividend per share for year ‘t’ payable at the end of year
Pt = Price per share at the end of year ‘t’