The Risk Premium explained.

The Risk Premium (RP) is the additional rate of return that investors expect to receive for taking on more risk when investing in stocks. This premium is above the Risk-Free Rate, which is the return that investors expect from a risk-free investment.

Investors should be compensated for taking on additional risk compared to what they would earn in a lower-risk option. Instead of asking whether an investment is good or not invert the question. Ask what return you want to receive for investing in a particular stock. Then consider whether this return is adequate compared to a safer alternative.

There are two types of Risk Premiums: Equity Risk and Market Risk. ERP is the additional return that investors expect to receive from investing in an individual company’s equity. The premium is linked with the riskiness of the stocks, which means that a higher-risk stock requires a higher equity risk premium to be attractive to investors. MRP is the additional return that investors require to hold a market portfolio, such as an index or exchange-traded fund.

The RP helps investors compare investment opportunities with different levels of risk. The higher the risk, the higher the expected return because there is always a trade-off between reward and risk.

The RP is unique to every investor’s strategy, goal, and risk appetite. Every stock has a cost of equity, which is the percentage of returns payable by the company to its equity shareholders. This cost is a guide for investors to decide whether an investment is rewarding or whether other opportunities carry a better risk/reward payoff.

The Risk Premium is associated with the Capital Asset Pricing Model to determine the Cost of Equity for individual companies.

What is the Risk Premium formula?

• Return On Investment = The return on an investment opportunity. What a company needs to offer as a return to entice investors.
• Risk-Free Rate = The rate from zero-risk investment instruments such as the 10-year Government bond.

How to use the Risk Premium?

I generally use the Risk Premium after I have calculated the Cost of Equity using the Capital Asset Pricing Model. This is because the RP for me is related to the specific company I am interested in and what it would need to be for me to buy in. However, let’s use an example suggesting we have worked out the Equity Premium of a specific company. The RP helps investors better make asset allocation decisions. Individual investors apply RP and the CAPM to inform decision-making.

In our example, the company is a small-cap stock showing some great growth prospects with a long runway ahead. Being a new company there is a lot of volatility and risk associated with the business. We calculate the cost of equity and theoretical rate of return and now want to compare it to a Risk-Free option.  

Risk Premium
Capital to Invest	$150,000
Equity Risk Premium	17.5%
Risk-Free Rate	3.5%
Return on Investment	$26,250
Risk-Free Return	$5,250
Risk Premium	$21,500

To see how we work this out let’s break down the calculations below, starting with the capital we want to invest of $150,000.

Return on Investment $150,000 x 17.5% (Equity Premium from the Company) = $26,250

Risk-Free Return $150,000 x 3.5% (The zero risk 10-year bond) = $5,250

Premium for the Risk $26,250 – $5,250 = $21,500

So, we can determine whether the return is appropriate for the level of risk involved. It’s crucial to note that this depends entirely on the stock’s performance. As investors, it’s essential to grasp the risk by conducting thorough research on the stock before deciding whether to invest.

In Summary…

I often use this formula to analyse various investments to determine the real risk premium. This helps investors to better understand opportunity costs. Although it may take some time to understand the formula, it can change the way you view investments.

When you analyse the risk/reward payoff, investments that seem appealing because of their story may not be as attractive.

While this formula is a simple method, it is not the only method. The premium is rarely determined in isolation and is typically used alongside the Capital Asset Pricing Model.

A higher equity risk premium indicates higher market risk. Investors should ensure that they receive adequate rewards for the extra risk they take. The size of the premium is subject to change and depends on the level of risk in a particular portfolio or business. It changes over time, especially as the market risk fluctuates.

When the equity risk premium is high, investors may consider investing in stocks. When it is low, fixed-income securities may be more appealing.

Determining an equity risk premium is theoretical because it is impossible to predict how well equities or the equity market will perform in the future.

When evaluating an investment idea think about the type of return that would make this idea viable. Let’s say you wanted to achieve a premium of 10% above the Risk-Free rate for adding risk exposure. If the risk premium comes back at this then it is a fair deal.