Conclusion
The return required by an investor in an individual equity share is made up of three components:
- the risk-free rate
- the equity risk premium
- a reward adjustment for the volatility of a share relative to the market as a whole.
The first of these components of the return required by an investor on an individual share, the risk-free rate, was looked at. It can be thought of as the yield on a government bond or on a short-term government bond, which is called a Treasury bill. You saw the differences in yield required on government debt according to which the country’s debt is being considered: Greece was used as an example. You also saw how government bond yields vary according to the maturity of the particular bond, and how this can be represented in a yield curve. Such yield curves can have different shapes, the most common being flat, rising, humped and falling.
The second element of the return required by investors for investing in individual shares, the market premium or the equity risk premium, was then considered. This is the difference between the risk-free rate (either the Treasury bill rate or a government bond yield) and the average return expected to be earned on the equity market as a whole. There are three ways in which this can be calculated: by using historical data, by asking experts, or by estimating the implied future equity risk premium from today’s stock market index value.
The Open University course B858 Introduction to corporate finance [Tip: hold Ctrl and click a link to open it in a new tab. (Hide tip)] looks in detail at the third element of the expected return on equity, that is, the element of expected return that takes account of the share’s volatility relative to the volatility of the equity market as a whole.