Tegus’ roots run deep in the institutional investing space. As such, we are visiting common financial concepts and terms to inform and educate individuals who are newer to existing frameworks and the accompanying nomenclature. First on deck is equity risk premium.
Equity risk premium is a crucial concept for investors to understand as it can help them make informed investment decisions. Defined as the excess return that an investor expects to earn on a stock when compared to a risk-free asset such as a government bond, equity risk premium represents the compensation that an investor requires for taking on the higher risk of investing in equities.
In other words, the equity risk premium is the amount by which the return on a stock investment is expected to exceed the return on a risk-free investment over a given period of time. By taking the premium into account, investors can make portfolio choices that are aligned with their risk tolerance and that support their investment goals.
Last year rounded out with an average equity risk premium reported at 5.6%. However, it’s a constantly changing figure that depends on a variety of factors, including the current state of the economy, the overall market and investor sentiment.
Generally speaking, it tends to be higher during times of uncertainty or market volatility, as investors require compensation to adjust for the added risk. Conversely, during periods of stability and growth, the premium may be lower. It is important to note it is an estimate that varies greatly depending on its method of calculation as well as the specific stocks or market index being analyzed. There are several methods to calculate equity risk premium, but the most common method is to subtract the return on a risk-free investment, such as a government bond, from the expected return on a stock market index, like the S&P 500.
The risk-free rate is a theoretical rate of return on an investment that is considered to be completely risk-free. In practice, there is no such thing as a completely risk-free investment, but the risk-free rate is often used as a benchmark to evaluate other investments.
In the context of the equity risk premium, the risk-free rate is used as a reference point to calculate the excess return that investors expect to receive from holding equities over a low-risk, fixed-income investment. For example, if the return on a US Treasury bond is 2% and the expected return on the S&P 500 is 8%, the equity risk premium would be calculated as 6% (8% - 2%).
The risk-free rate is typically based on the yield on a US Treasury bond, as these bonds are considered to be among the safest investments available. Other low-risk, fixed-income investments, such as certificates of deposit (CDs), can also be used as a benchmark for the risk-free rate, although the yield on a US Treasury bond is the most commonly used benchmark in financial markets.
It is important to note that the risk-free rate is a theoretical construct and can vary over time depending on macroeconomic conditions and other factors. As such, it is important to regularly update the risk-free rate and to use it in conjunction with other information and analysis when making investment decisions.
There are several niche forms involved in equity risk premiums, and they are as follows:
The implied equity risk premium (IERP) is a forward-looking estimate of the equity risk premium, derived from equity market data. It is calculated by observing the current prices of stocks, bonds and other financial instruments, and then using that information to estimate the expected excess return on equities in the future. This estimate can be compared to historical averages to see if the market is expecting higher or lower returns in the future.
In contrast, regular or historical premiums are a backward-looking estimate that is calculated by subtracting the average return on a risk-free asset from the average return on a stock market index over a specified period. Since it looks at a given period of time, it doesn’t necessarily take into account current markets or expectations. Both the implied and historical equity risk premium have their uses in financial analysis, but the implied is considered to be more relevant for current conditions as it reflects the expectations of market participants.
Negative equity risk premium occurs when the expected return on stocks is lower than the return on a risk-free asset. In other words, investors expect to earn less from holding equities than from holding a low-risk, fixed-income investment.
This situation arises when there is a high level of uncertainty in the market – as during a recession or a financial crisis. In such times, investors may be more risk-averse and demand a higher premium for taking on the additional risk of investing in stocks which can result in lower expected returns on equities and a negative equity risk premium. Negative equity risk premiums are not a common occurrence and are usually indicative of a bear market or a financial crisis. In more normal market conditions, the equity risk premium is usually positive.
This refers to the premium that investors demand as compensation for the risk associated with investing in equities, from the perspective of the supply of investment capital. This approach to calculating the equity risk premium considers factors such as the cost of capital for corporations and the availability of investment capital in the market.
The supply-side equity risk premium takes into account the trade-off between risk and return for investors, as well as the cost of capital for companies seeking to raise funds through equity issuance. For example, if the cost of capital for companies is high, they may have to offer a higher return to investors to compensate for the additional risk they are taking on, which would result in a higher equity risk premium. Similarly, if there is a large supply of investment capital available in the market, investors may be less likely to demand a high premium for taking on risk, which could result in a lower equity risk premium.
This approach to calculating the equity risk premium can provide valuable insights into the current market conditions and the factors that are driving the demand for and supply of investment capital. It is one of several methods used to estimate the equity risk premium and is often used in conjunction with other methods to provide a more comprehensive view of the market.
Widely used in the US market, the Duffs & Phelps equity risk premium is calculated and published annually by its namesake, a leading financial advisory and investment banking firm. Based on a forward-looking approach that looks at current market conditions and expectations, as well as a review of historical data and macroeconomic factors, the Duff & Phelp premium is calculated as the difference between the expected return on the S&P 500 index and the yield on a 10-year US treasury bond and is expressed as a percentage of the current market value of the S&P 500. Most commonly used as a benchmark for estimating the equity risk premium, many financial professionals and institutions apply it further in a variety of contexts, including valuing companies and assets, evaluating investment opportunities and developing financial projections.