The Risk-Free Rate (RF) is the rate of return investors expect from holding "safe" investments such as long-term U.S. government securities, which are considered virtually free of risk of default because of the stability of the U.S. government. The return demanded by investors consists of two elements: the "pure" or "real" interest rate (compensation for making the investment) and the compensation for expected inflation.
Risk-Free Rate = "Real" Interest Rate + Expected Inflation Rate
The rate of return on common stock (from dividends and stock price appreciation) is less certain (i.e., riskier) than the relatively predictable returns available from U.S. government bonds. As compensation for the higher risk involved in owning common stock, investors demand a rate of return on stocks that is greater than the Risk-Free Rate. Therefore the rate of return on stock equals the Risk-Free Rate plus a "risk premium" for holding that stock rather than holding U.S. government bonds.
For the Risk-Free Rate, it is wise to use the current rate on long-term government bonds, which is quoted daily in publications such as the Wall Street Journal and the Financial Times. The use of short-term rates such as the current rates on Treasury bills is not recommended because they incorporate expectations about only short-term (i.e., less than 90 days) inflation. Using the longest term Risk-Free Rate available incorporates expectations for inflation and interest rate fluctuations.