What is Equity Risk Premium?
Investing in equity is not risk-free. The risk is not only associated with returns but the capital is also not guaranteed. So, to compensate for the risk, the investor must get an extra/excess return. It is actually the difference between the return provided by a risk-free investment and the return provided by individual stock over the same period of time. This difference in return is known is equity risk premium.
It is one of the key elements while calculating expected return from equity (cost of equity) using CAPM. CAPM is used for evaluating the expected rate of return from a stock. It actually helps the investor decide whether his investment in the stock is worth or not and does the return commensurate with the risk he is taking?
Let’s see how to calculate equity risk premium.
- Take Equity Market expected return. Generally, broader market indices represent the market. So, take the expected return from the broader market index. E.g. in the case of the U.S., S&P500 represents the broader market, in the case of India, Nifty/Sensex represents the broader market.
- Take return of the risk-free bond, which is a return from U.S. Treasury bill in the U.S.
- Deduct risk-free return from expected equity return and multiply it by Beta of stock. [Beta measures the volatility or systematic risk of the stock. Because the market has a beta of 1, while calculating the market risk premium, we omit it.]
1. Calculate expected market risk premium if expected return from S&P500= 8%, return from US 10 year T Bill= 3%
Equity Risk Premium= Expected equity Market Return – Risk Free Return = 8% – 3% = 5%
2. Taking the same expected return and return from the US, calculate equity risk premium and expected the return from the stock of Apple if, Beta of stock is 1.3.
Equity Risk Premium= (Expected equity Market Return – Risk Free Return)*Beta = (8%-3%)*1.3 = 6.5%
Expected Return = Risk Free Return + Risk Premium = 3%+6.5% = 9.5%
So, taking into consideration the risk an investor is taking in Apple, he must get at least a 9.5% return.
3. Taking the same expected return and return from the US, calculate equity risk premium and expected the return from the stock of Berkshire if Beta of stock is 1.5.
Equity Risk Premium = (Expected equity Market Return – Risk-Free Return)*Beta = (8%-3%)*1.5 = 7.5%
Expected Return = Risk Free Return + Risk Premium = 3%+7.5% =10.5%
Same way, the investor will expect atleast 10.5% return from Berkshire taking into consideration the risk he faces.
Do Different Equity Stocks have Different Risk Premium?
The answer to the above question is YES. As we have seen in the above example that depending upon the stock volatility in the past, different stocks carry a different risk premium. Generally, Large Cap Blue chip stock has a lower equity risk premium than Midcap Stock.
Higher equity risk premium indicates higher risk. Hence, the investor will also expect higher returns.
- Easy to use.
- Gives investor an immediate idea of whether or not the stock is worth investing. As the investor needs to be adequately rewarded as against the risk.
Equity Risk Premium is highly subjective in nature. As we take assumptions while calculating input, each investor might get different equity risk premium for the same stock. So, the expectation of the return from the same stock can be different for the different investor. Eg. While taking an expected market return someone might take the Historical return of the market over a period of 3-5 years whereas another investor would use the Dividend Discount model or some other method to calculate equity market return.
Due to its easiness and application in day to day investments in real practical life, it is widely used among investors.1,2