Equity Risk Premium

For an investor to invest in a stock, the investor has to be expecting another return than the risk-free rate of return; this additional return is known as the equity risk premium because this is the additional return expected for the investor to invest in equity.

In simple words, Equity Risk Premium is the return offered by individual stock or overall market over and above the risk-free rate of return. The premium size depends on the level of risk undertaken on the particular portfolio, and the higher the risk in the investment higher the premium will be. This risk premium also changes over time concerning the fluctuations in the market.

The equity risk premium calculation refers to the compensation in the form of extra return that investors expect to earn from an investment based on the additional risk that they take. It is a comparison between the risk-free return and the return in stock investment.

The extra return is the premium earned due to market volatility. It protects the investors from probable loss of capital and the higher risk level compared to investments that are considered safe.

However, the risk free rate taken into consideration in the calculation of average equity risk premium is the yield from government bonds or from any other fixed income or low risk investment opportunity. They are considered to have negligible investment risk.

Image Source: Financial Modeling and Valuation Course Bundle

This gives the prediction to the stakeholders of the company that the stocks with high risk will outperform when compared with less risky bonds in the long-term. There is a direct correlation between risk and the Equity risk premium. Higher the risk will be the gap between the risk-free rate and the stock returns, and hence premium is high. So it is a very good metric to choose stocks worth the investment.

Thus, we see that the current and historical equity risk premium is a very important concept used in the financial market for investment purpose. The investors can assess their rewards in investing in different avenues by using the premium as a benchmark and comparing different options like bonds, real estate, etc. This helps in a strong and balanced portfolio construction.

For calculating this, the estimates and judgment of the investors are used. The The equity risk premium calculation is as follows:

Firstly we need to estimate the expected rate of return on the stock in the market, then the estimation of the risk-free rate is required, and then we need to deduct the risk-free rate from the expected rate of return.

Equity Risk Premium Formula:

Equity Risk Premium = Market Expected rate of return(Rm) - Risk Free Rate (Rf)

The stock indexes like Dow Jones industrial average or the S&P 500 may be taken as the barometer to justify arriving at the expected return on stock on the most feasible value because it gives a fair estimate of the historical returns on the stock.

As we can see from the formula above that the market risk premium is the excess return that the investor pays for taking the risk over the risk-free rate. The level of the risk and the equity risk premium is correlated directly.

Let's take the example to calculate long term equity risk premium where we use of a government bond giving a return of 4% to the investor; Now, in the market, the investor will choose a bond that will give a greater than 4% return. Suppose an investor choose a company stock giving a market return of 10%. Here the equity risk premium will be 10%- 4% = 6%.

The interpretation of short or long term equity risk premium are as follows:

• We know the risk associated with debt investment, as the investment in bonds, is usually lower than that of equity investment. Like that of preferred stock, there is no surety of receiving the fixed dividend from the investment in equity shares as the dividends are received if the company earns a profit and the dividend rate keeps on changing.
• People invest in equity shares, hoping that the value of the share will increase shortly and they will receive higher returns in the long term. Yet there is always a possibility that the value of a share may decrease. This is what we call the risk that an investor takes.
• Moreover, if the probability of getting a higher return is high, the risk is always high. If the probability of getting a smaller return is high, then the risk is always lower, and this fact is generally known as a risk-return trade-off.
• The return that an investor on a hypothetical investment can receive without any risk of having financial loss over a given period is known as the risk-free rate. This rate compensates the investors against the issues arising over a certain period like inflation. The rate of the risk-free bond or government bonds having long-term maturity is chosen as the risk-free rate as the chance of default by the government is considered to be negligible.
• The riskier the investment, the more is the return required by the investor. It depends upon the investor's requirement: risk-free rate and equity risk premium help determine the final rate of return on the stock.

Each country has a different Equity Risk Premium. This primarily denotes the premium expected by the Equity Investor. For the United States, Equity Risk Premium is 6.25%.

source – stern.nyu.edu

• Equity Risk premium = Rm – Rf = 6.25%

The CAPM model explained in the Valuation Course is used to establish the relationship between the expected return and the systematic risk of the securities of the company. CAPM model is used to price risky securities and calculate the expected return on investment using the risk-free rate, expected rate of return in the market, and the beta of the security.

The equation for CAPM:

Expected Return on security = Risk-free rate + beta of security (Expected market return – risk-free rate)

= R_f +(Rm-Rf) β

Where R_f is the risk-free rate, (R_m-R_f) is the equity risk premium, and β is the volatility or systematic risk measurement of the stock.

In CAPM, to justify the pricing of shares in a diversified portfolio, It plays an important role in as much as for the business wanting to attract the capital it may use a variety of tools to manage and justify the expectations of the market to link with issues such as stock splits and dividend yields, etc.

Suppose the rate of return of the TIPS (30 years) is 2.50% and the average annual return (historical) of the S&P 500 index by 15%, then using the formula equity risk premium of the market would be 12.50% (i.e., 15% – 2.50%) = 12.50%. So here, the rate of return that the investor requires for investing in the market and not in the risk-free bonds of the government will be 12.50%.

Apart from the investors, the company managers will also be interested as the equity risk premium will provide them with the benchmark return, which they should achieve for attracting more investors. For instance, one is interested in XYZ Company's equity risk premium, whose beta coefficient is 1.25 when the prevailing equity risk premium of the market is 12.5%. Therefore, he will calculate the company's equity risk premium using the details given, which comes to 15.63% (12.5% x 1.25). This shows that the rate of return that XYZ should generate should be at least 15.63% for attracting investors to the company rather than risk-free bonds.

Just as every financial concept has its own advantage and disadvantage, so does this concept. Let us look at them in details.

Advantages

• Using this premium, one can set the portfolio return expectation and determine the policy related to asset allocation. For example, the higher premium shows that one would invest a greater portfolio share into the stocks.
• Also, CAPM relates the stock's expected return to equity premium, which means that a stock with more risk than the market (measured by beta) should provide an excess return over and above equity premium.
• Thus in a way it provides a measure to assess the risk and return trade-off while designing the portfolio for investment.
• The historical equity risk premium helps in prediction of return expectations from a stock in future, which leads to adjustment of investment strategies.
• It helps in comparing different investment options and choose the one with maximum return with minimum risk and cost. Comparison is done with asset classes and investors can take informed decisions regarding investments.

Drawbacks

• On the other hand, the drawback of average equity risk premium calculation includes the assumption that the stock market under consideration will perform in the same line as its past performance. No guarantee is there that the prediction made will be real.
• Different financial models offer different theories on the measurement of the premium which leads to ambiguity. This lack of consensus proves to be challenging.
• It may be influenced by investor sentiments. They may be irrational and be biased regarding various factors that influence the premium. This distorts the accuracy level, risk factor and return expectations, affecting the premium value.
• The market dynamics are never static. They change with time and as per investor preference. It requires continuous tracking and monitoring to understand and make adjustment as per the current market conditions.

Both the above concepts explain the different types of risk premium in the financial market, but they differ in many ways. Let us find the differences between them.

• The former is the excel return from stock in comparison with the risk free rate of return but the latter represent the excel return from the broader market index in comparison with the risk free return.
• The former is equity focussed whereas the latter is market focussed.
• The market risk premium is a broader term whereas the equity premium is a part of the market premium.
• The market premium depends on market volatility, industrial trends or economic conditions whereas the equity premium depends on the volatility of the particular stock.

Thus, both of them are essential concepts and both are used to determine additional return to investors.