Last updated on Feb 2, 2024

What is the appropriate risk premium to use when calculating the cost of equity?

When you want to estimate the cost of equity for a project or a company, you need to consider the risk premium that reflects the extra return that investors demand for holding risky assets. But how do you determine the appropriate risk premium to use in your calculations? In this article, you will learn about the concept and the methods of estimating the risk premium for the cost of equity.

1 What is the risk premium?

The risk premium is the difference between the expected return on a risky asset and the risk-free rate. The risk-free rate is the return on an investment that has no default or market risk, such as a government bond. The risk premium reflects the compensation that investors require for bearing the uncertainty and volatility of the risky asset. The higher the risk, the higher the risk premium.

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Eduardo Cerezuela

✔ LinkedIn #TopVoice in 2 disciplines: #Business Strategy & #Business Management ✔#M&A Processes Consultant ✔Enterprise & Project Valuation ✔Economy & Financial Expert ✔Board Advisor✔#Mentor ✔Guest Podcast Speaker
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Complementando este apartado me gustaría aportar una posible definición previa de rentabilidad esperada de un activo. En efecto, esta estaría supeditada al comportamiento presente de los flujos de fondos netos proyectados, entre los ingresos, egresos, escudo fiscal, capital de trabajo neto incremental y necesidades de reinversión en bienes de capital. Es fácil notar que esta tasa de rendimiento esperado está supeditada a que se cumplan las proyecciones y estas a su vez, dependen de la certeza con la que se vienen cumpliendo las reglas de juego del sector. Por lo que la diferencia entre la tasa de rendimiento esperada -que incluye el grado de certeza mencionado- y la tasa libre de riesgo, es lo que se denomina prima de riesgo.

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Clint Engler

CEO/Principal: CERAC Trader Strategies Inc. FL USA..... Currencies/Digital Assets, Economy, & Finance
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It all depends on the hat you pull from! There's no one-size-fits-all, and choosing the right one can feel like juggling live spreadsheets while blindfolded on a unicycle. Here's a quick rundown: Look at historical averages or current estimates of the stock market's return over risk-free rates. Consider the company's size, riskiness, and industry to adjust the market premium. CAPM: Use a fancy formula with betas and expected market returns to calculate the premium. This is like pulling a mathematical rabbit out of a theoretical hat - impressive, but maybe a bit dusty. Remember, no matter which hat you choose, be sure to consider things like economic conditions, investor sentiment, and your own tolerance for financial magic tricks.

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2 Why is the risk premium important for the cost of equity?

The cost of equity is the rate of return that shareholders expect to earn on their investment in a company or a project. It is one of the key inputs for the capital asset pricing model (CAPM), which is a widely used method to calculate the cost of equity. The CAPM formula is: Cost of equity = Risk-free rate + Beta x Risk premium Beta is a measure of the systematic risk of the asset, which is the risk that cannot be diversified away by holding a portfolio of assets. It shows how sensitive the asset's return is to the movements of the market return. The risk premium in the CAPM formula is also called the market risk premium, which is the difference between the expected return on the market portfolio and the risk-free rate.

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3 How to estimate the risk premium for the cost of equity?

When estimating the risk premium for the cost of equity, there are various approaches depending on the availability and reliability of data and assumptions. The historical method uses the average difference between the returns on the market portfolio and the risk-free rate over a long period of time. For instance, if the average annual return on the S&P 500 index was 10% and the average annual return on the 10-year Treasury bond was 2% over the last 50 years, then the historical risk premium would be 8%. However, this method assumes that past performance is indicative of future expectations. Alternatively, survey method utilizes opinions and forecasts of experts, analysts, and investors to estimate the risk premium. This approach relies on subjective judgments and biases of respondents, which may not be consistent or accurate. Lastly, implied method uses current market prices and earnings of companies to calculate the cost of equity using dividend discount model (DDM), subtracting the risk-free rate from it. DDM formula is: Cost of equity = (Dividend per share / Stock price) + Growth rate of dividends . Nevertheless, this method relies on quality and availability of dividend and earnings data which may not be stable or representative of future growth prospects.

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Maulik Nagri

Experienced Finance Executive | FP&A Process Builder | Shareholder Value Creator | SaaS Finance Expert | Profitable Growth Driver | Top Corporate FP&A Voice on LinkedIn
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A simple calculation for the risk premium is the average difference between a broad stock market index and risk-free bonds (traditionally government treasury bonds) over a long period of time (20-30 years). More sophisticated adjustments to risk premium for calculating the cost of equity include those for country, sector, size, and momentum. Attention is invited to Fama French's multi-factor models for calculating the cost of equity.

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4 How to choose the best risk premium for the cost of equity?

When considering the best risk premium to use for the cost of equity, there is no definitive answer as different methods may yield different results. The choice of risk premium is dependent on the purpose and context of the analysis, as well as the preferences and assumptions of the analyst. Factors that may influence the selection of risk premium include the time horizon, market conditions, industry, and country. For instance, when considering a long-term perspective, the historical method may be more suitable while the survey or implied method may be more relevant for a short-term outlook. Additionally, risk premiums may also adjust according to economic and financial conditions of the market or differ between industries and countries depending on their risk characteristics and growth opportunities. Therefore, it is important to adjust and use specific or relative risk premiums that reflect current or expected market conditions.

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5 How to apply the risk premium for the cost of equity?

Once the analyst has chosen the appropriate risk premium for the cost of equity, they can use it to calculate the cost of equity using the CAPM formula or other models. The cost of equity is an important component of the weighted average cost of capital (WACC), which is the overall cost of financing for a company or a project. The WACC formula is: WACC = (Cost of equity x Equity weight) + (Cost of debt x Debt weight x (1 - Tax rate)) The WACC is then used as the discount rate for the net present value (NPV) analysis, which is a method to evaluate the profitability and feasibility of a project or an investment. The NPV formula is: NPV = Present value of cash inflows - Present value of cash outflows The NPV shows the difference between the value of the project or investment and its cost. A positive NPV indicates that the project or investment is worth pursuing, while a negative NPV indicates that it is not.

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6 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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Sylvain Mestrallet

VP Finance / Finance Executive @GE HealthCare | Embracing global perspectives 🌍
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Consistency - using the same risk premium - across an organization is critical, especially to compare business cases and returns.

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Eduardo Cerezuela

✔ LinkedIn #TopVoice in 2 disciplines: #Business Strategy & #Business Management ✔#M&A Processes Consultant ✔Enterprise & Project Valuation ✔Economy & Financial Expert ✔Board Advisor✔#Mentor ✔Guest Podcast Speaker
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Me gustaría añadir que cada método de valuación tiene sus limitaciones, es por eso que, para llegar a determinar un valor más justo de un activo es necesario apoyarse con varios métodos y contrastarlos. No hay que olvidar que inclusive el método de valorización más difundido, que es el del flujo de fondos libre descontado por la WACC, tiene su limitación. En efecto, la WACC surge una una ponderación de la estructura de capital que el modelo la considera constante a través de los años y en la práctica esto cambia debido a muchos factores, como la política de dividendos y de financiamiento, el riesgo de cambio, el riesgo país, la tasa de interés, etc. Es mucho más probable que la estructura de capital se modifique a que permanezca constante.

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What is the appropriate risk premium to use when calculating the cost of equity?

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1 What is the risk premium?

2 Why is the risk premium important for the cost of equity?

3 How to estimate the risk premium for the cost of equity?

4 How to choose the best risk premium for the cost of equity?

5 How to apply the risk premium for the cost of equity?

6 Here’s what else to consider

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