3.4 Finding an equity risk premium
Complete the activity below to find an equity risk premium.
Activity 4 Finding an equity risk premium
‘Finance is an art. And it represents the operations of the subtlest of the intellectuals and of the egoists.’
The following data was taken from Bloomberg on 13 December 2013. We have extracted three countries for you to review.
The implied equity risk premium is the difference between the market return and risk-free rate. The market return has been calculated using the growth rate. Bloomberg does not give the exact method for its approach but we will accept the results in the table as they are.
| Country | Growth rate (%) (consensus five-year projected growth) | Risk-free rate (%) (yield on ten-year treasury security) | Market return (%) (average yield taking account of all major index companies) | Implied equity risk premium (%) |
| US | 11.85 | 2.87 | 9.98 | 7.12 |
| China | 13.62 | 4.61 | 14.14 | 9.53 |
| Indonesia | 8.80 | 8.56 | 10.13 | 1.58 |
Look at the equity risk premium:
- What reasons can you give for the different premiums?
- What do the differences tell you about the perceived risk and return from investing in companies in those countries?
Hint: information on stock market movement and other economic indicators is available from the Trading Economics website [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] . (Trading Economics (2011) Stock Market Indexes, taken from http://www.tradingeconomics.com. With kind permission.)
Remember that this website will have current information and the Bloomberg equity risk premium ‘snapshot’ given in this exercise was taken in December 2013. If you see any anomalies, think about economic events, both global and country-specific, which may have occurred since December 2013.
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Feedback
There is a huge 7.95% spread between the three equity risk premiums quoted in Bloomberg on 13 December 2013.
We suggest the following:
China offers the highest market return and the highest equity risk premium, reflecting the forecast of China’s future real growth in relation to the risk-free rate.
Indonesia offers the second higher market return, but very close to the relevant US one. The global recession in 2008 took the stock market down to its 2006 level, but the stock market has fully recovered its upward path since then, being stabilised in considerably high levels. Although Indonesia offers the lowest equity risk premium, this is partly due to the very high prevailing interest rates.
A base rate is an interest rate set by banks. This determines borrowing and lending rates.
The US market return is the lowest of the three countries and its historic trend has been affected by the low growth in the wake of the 2008 financial meltdown. At the time of writing, IMF economic forecasts suggest an economic recovery in the future and this anticipation is reflected in the considerably high consensus dividend growth forecast (11.85%). The US equity risk premium is much higher than Indonesia’s due to the low US risk-free rate, which reflects to some extent the low base rate of the Federal Reserve in an effort to kick-start the US economy.
Using an implied approach to calculate the equity risk premium, as in the Bloomberg ‘snapshot’, means that you inevitably take account of historic events captured in the current risk-free rate (such as the lowering of the risk-free rate in the USA). Such events may not happen again in the future.
Point to note…
If you use an implied equity risk premium approach when finding a discount rate for use in a valuation or investment appraisal, consider other factors that contribute to the premium result.
In particular, think of the approach in calculating the market return. The Bloomberg approach is to use the consensus five-year projected growth forecast to calculate the return.
Can you think of any disadvantages of this?
One disadvantage is that you are using a consensus view of future growth that may not materialise.