Market Risk Premium
(Equity Risk Premium)
Every investment carries some level of risk and some level of potential return. Those two measures are closely related in investment finance and are used in CAPM which calculates cost of equity. Equity risk premium (part of equity cost) is a theoretical annual return percentage of stock market above the risk-free rate. It means that equity market should outperform risk free market (bonds of highest safety governments) by this annual rate on average.
There are many ways to determine market risk premium, but basically there are two main approaches:
1) Historical risk premium is calculated using the formula that is above but ‘historical market return’ is used instead of ‘expected stock market return’. Historical market return is calculated using long term (decades) US market data (stock market, T-Bonds, T-Bills) and calculated as average. Although the market is one, different outcomes are used in practice. The differences appear because different period, different maturity securities, different mean methods (arithmetic or geometric) can be used. Others are even using data of other markets. However, the most accredited and most used in practice meaning of ‘equity risk premium’ calculated by this method is equal to 4%.
When this approach is used, equity risk premium does not change when market fluctuates and stays at the same level over time. This means that when stock market is high, most of the stocks look overvalued, but when the market is low, stocks look undervalued despite the attitude to the risk.
2) Implied risk premium is calculated using the freshest data of stock market. Basically, this method tries to predict the potential average annual return for the future period using pricing data in relation to the cash flow or earnings generation. There are many modifications that are used to calculate implied market risk premium. Some analysts are using dividend yield average of the stock market plus dividend growth, others use free cash flow yield of the market, while others may use some similar or adjusted yield that would represent annual return of the stock market for future periods.
When this approach is used, equity risk premium is changing all the time depending on the rises and falls of the market. When implied risk premium is used, the overall market looks neither overvalued nor undervalued, and the results of valuation are based more on particular security and its analysis.
It is hard to say which attitude is more correct, and it depends on believes and goals of the analyst. Investors’ attitude to the risk is continuously changing over time and there is a psychological factor as well: investors are avoiding equity investments when market is low and forgetting about the fears when market is high. So, it is hard to say whether the stock valuation should include such influence of psychological factors when deciding if stock is overvalued or undervalued. In the other hand, valuation using implied market risk premium is more accurate because investor seeks for higher return from riskier investments during troubled times than in the calm market, so this forward oriented risk premium promises higher average annual return from a stock, but the target price looks lower.
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