Investments in securities and the equity markets are common vehicles for increasing the value of capital. Which type of investment is best? The calculation of equity risk premium provides the answer. Risk-free investments like government bonds and U.S. Treasury bills offer minimal risks, but they pay low interest resulting in lower returns in comparison with equity investments. Equity investments impose greater risks and typically pay greater returns over time.
Equity Risk Premium
The calculation of equity risk premium identifies the percentage of return that exceeds the yield on risk-free investments. The assumption with risks in investments is that higher risks should yield higher returns that risk-free investments. The equity market naturally raises the risk level due to the volatility of the stock market.
The equity market consists of shares of stock in companies. Stock shares represent public ownership in firms. The equity value of companies fluctuates as the income to debt ratio changes over time. Net profits contribute to equity value. Equity value at the end of reporting periods is the basis for determining shareholder dividends.
Calculations of Return
The calculation of the equity risk premium subtracts the risk-free investment return from the returns on equity investments. For instance, if the return on a stock is 15% and the return on risk-free investments was 8% for the same time period then the equity risk premium was 7%. Most investors base performance on the required rate of return. A required rate of return is the minimal return that is acceptable to the investor. The required rate of return includes consideration of additional factors such as the net present value of investments, present value of cash flows, and inflation.
The capital asset pricing model is another method for calculating investment risks. The model includes the risk-free rate, the equity market premium, and the stock’s beta. Beta is the estimate of volatility inherent with the stock. For example, a stock with a beta of 1.5 would rise or fall by 15% if the market moves by 10% in either direction. The model calculates the equity market premium by its beta. The solution reveals the risks incurred with an investment.
The world of investing can be a confusing and frustrating place. Investors naturally want to minimize risks and maximize profits. Mitigating risks can be accomplished through risk-free investments but these yield low returns. The desire to maximize returns cannot avoid risks. The equity market premium is an essential calculation that can assist investors in determining when an investment might be too risky.