Over time we are witnessing the increasing trend in the global stock market investment. People, who own money in a retirement plan or personal saving, always want to allocate finance in a scheme they feel better for them such as bonds, cash, and stocks. Millions of people do investment in the stock market to gain maximum profit and gain financial strength.
Companies and individuals do plans long-term equity returns for capital and economic growth. In this regard, the equity risk premium (ERP) is one of the significant investment strategies to enhance the money value and receive access returns. ERP depicts how much more the capitalist would earn by doing investment in stock exchange compared to the government bonds. The purpose of this article is to help people in making better investment decisions by giving knowledge about equity risk premium. This includes the way how to calculate equity risk premium.
Table of contents
What is Equity Risk Premium?
Equity risk premium (ERP) is defined as the additional return available for the investor by investing in the stock market issue over the risk-free return. In simpler words, it is the difference between individual stock or equity return and the risk-free return rate. It is an additional profit a stock pays to the investors over and above the risk-free charge for the chance investor is taking.
The extra return recompense investor for taking a comparatively big risk of investment at equity. The premium size relies and varies on the level of risk in a certain portfolio. ERP is the recoupment to the holder for going for a greater level of risk by investing in equity alternately to riskless securities. Riskless investment involves Cash, T-bills, and T-bonds, etc.
How Does Equity Risk Premium is used?
The investment in the stocks is usually considered high-risk financing in comparison to other investment schemes. A stock investment contains certain risk factors, but there is also scope for capitalists to gain good financial rewards. There are chances of receiving higher premiums through ERP stock investment. It is based on the concept of risk-reward tradeoff. The government bond performance and stock market performance over a decided time period and historical performance are utilized to the possibility of future return.
The equity investors strive to maintain balance among return and risk. When the companies peruse equity investment capital, they should give a premium to engage the equity investors. For instance, if an investor could obtain a 6% return through a non-risk investment government bond. Thus, the company stock must provide a 7% return + extra return that would be the equity return which helps in attracting investors. Moreover, the rate of stock involving the equity risk premium proceeds with the market trends. Due to this, the investing parties utilize the ERP to analyze the risks, return on investment, and historical values.
How to Calculate Equity Risk Premium?
The estimation of ERP is can be performed by considering the estimated expected return on stocks and then subtraction is done from the estimated expected return on riskless bonds. To estimate future stock, a dividend based and earning based approach is used. The historical rate of return is required in the calculation of ERP. In a risk-free rate US T-Bills (Treasury Bills) are mostly used. Equity premium calculation is abstract as there no assurance of how well the equity market would perform in the upcoming days.
The formula of equity risk premium is as;
ERP = Stock Rate of Return – Risk-Free Rate
Three steps to follow for the calculation of ERP:
- Do the estimation of the expected rate of return
- Do the estimation of the risk-free rate
- Minus the difference to obtain equity risk premium.
We can also calculate the equity risk premium with Capital Asset Pricing Model (CAPM) which is the model to estimate the expected rate of return.
Ra = Rf + βa (Rm – Rf)
In this equation, Ra is a return on a security, βa is beta of “a”, Rf is the riskless rate of return, and where, Rm is the expected market return
Example and Calculation
Consider the scenario in which the return on a 5-year government T-Bond is around 6%. The stock market rate of return is 10% and the beta security of “a” is 3. So, the ERP according to the CAPM equation is;
βa (Rm – Rf) = 3 (10% – 6%) = 12%
Advantages of Equity Risk Premium
The ERP investment is easy to use a method that comes up with the following benefits;
- Equity risk premium projects how well a stock would outperform riskless over a longer period.
- It provides investors a great idea and analysis of whether to invest in stock or not. The investors can conveniently estimate the risk factors, rate of return, and historical values.
- ERP gives the opportunity to financial investors to receive the additional return.
- When we use equity risk premium with Capital Asset Pricing Model (CAPM) it builds a diversified portfolio via valuation of invested shares.
- It is an efficient tool for the businesses who want to attract capital, the dividend yield, and stock splits that are the market expectation of ERP are also effectively managed by this method.
Limitation of Equity Risk Premium
The major drawbacks of equity risk premium are as follows;
- Equity risk premium value keeps changing over time. There is a possibility each investor may obtain different ERP for the same stock.
- There is uncertainty in the economy; it is not confirmed to investors how the stock market will perform in the future.
In the global stock market, the equity risk premium (ERP) is a profitable method for investors. It provides additional return and financial benefits to investing parties. Hence, people should assign capital to stocks if the equity premium has a higher rate; if it is low then they should invest their portfolio to bonds. Investors should analyze what happened to stock value in the past and then form a prediction about what would be the most favorable outcomes of investments in the future.