Risk Premium

In the simplest terms, the risk premium is defined as the difference in annual returns between stocks and risk-free bonds. However, measuring it in practice is not an easy task.

Why is knowing the price of risk important?

The risk premium is the most fundamental pillar upon which projects, organizations, and investment proposals are evaluated and decisions are made. This indicator is the most sensitive factor influencing valuation results, regardless of the method used.

Below is a sensitivity analysis diagram for the value of a company based on a 10% change in three fundamental indicators. For every company I’ve analyzed similarly, I get a consistent picture: Enterprise Value is always more sensitive to changes in WACC than to changes in ROIC or Growth Rate.

Although there are several models for risk and return, they all agree on two points:

1. Risk is defined as the variation of actual returns from the expected returns, meaning if the expected profit equals the actual profit, there is no risk.
2. Risk is defined as the marginal investment in a portfolio, meaning the investor is diversified, and the corresponding reward for risk is expected only for non-diversifiable risks. This essentially divides risks into two parts: market risk (non-diversifiable) and company-specific risk (diversifiable).

Due to this perspective on risk, academics recommend that when evaluating a project or organization using the DCF method, specific risks should be accounted for in cash flows, while non-diversifiable risks should be reflected in the discount rate.

But what determines the price of capital risk?

There are several important components:

1. Risk aversion
2. Consumption preferences
3. Economic risk
4. Information
5. Liquidity
6. Catastrophic risk
7. Government policy
8. The behavioral/irrational component

All these components are very important and interesting, and I will delve deeper into them in future entries. In general, the following entries will primarily focus on the Equity Risk Premium.

*Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2013 Edition Updated: March 2013; Aswath Damodaran; Stern School of Business