How Is Risk Premium Measured?

There are several well accepted methods by which to estimate the proper return on equity (ROE) for a business, including the risk premium method. The risk premium method uses historic data on the spread between returns and the "risk-free" return in that period. The spread between the risk-free rate and the company's actual returns is forecasted to continue into the future under the risk premium method.

Function of Risk Premium

The risk premium helps determine whether an investment in a particular stock is likely to produce desired returns. Underlying the theory is the notion that a stock will behave in the future in a manner that is consistent with the way it behaved in the past. It also assumes that the fundamentals of the business, including the core sources of income, remain constant in order to maintain a consistent level for the risk premium in the future.

The risk premium method is simple. One simply compiles the difference between the investment's returns and the returns of a risk free investment in a year. Then, one compiles a data set using this method for a period of years to create an average figure. The average gap between the returns of the investment and the risk free returns is the risk premium. In theory, it is indicative of the investor's requirement of higher returns when risk increases.

Alternatives to the Risk Premium

In addition to the risk premium, forecasters of needed returns on equity often look to the capital assets and the expected income of the business. The Capital Asset Pricing Model (CAPM) is a commonly used alternative to the Risk Premium method. CAPM includes a measurement of risk for the investment by comparing it to a pool of alternative investments; this device is commonly called the beta of the stock. CAPM then uses the difference between the stocks returns and that of a generic proxy, such as the S&P 500, to forecast required returns.

Others prefer use of the Discounted Cash Flows, or DCF, model for forecasting required ROE. Unlike CAPM and the Risk Premium, DCF relies on forecasts of income from the investment relative to the expected income from a risk free investment.

Assumptions of the Risk Premium Method

The Risk Premium method of forecasting required ROE implicitly includes several assumptions that may not always be true. First, it requires that one assume that no fundamental change in the business has occurred in the time in which historic sample data was collected. This is not always the case.

Secondly, it assumes that macroeconomic events will not change the risk premium for an investment in the future. This assumption can be especially risky for investments in businesses that rely on government decisions. For example, the risk premium for a tobacco company has changed considerably over time and historic premiums may not be an accurate measure of future risks associated with the industry.

Computation of Risk Premium

The traditional method to compute the risk premium simply computes the difference in historic returns for a particular investment with the risk free returns that correspond with that time period. Typically, the risk free returns are determined by using the yields on U.S. Treasury Bonds. However, some practitioners prefer to use high grade corporate bonds or other proxies for a risk-free return.

Weaknesses of the Risk Premium Method

The risk premium method does not address all of the major incentives for investing in a business. For example, unlike the CAPM model, it only compares the returns of an investment to the risk-free rate. Many investors compare one stock versus another, which is more consistent with the CAPM model. Likewise, income investors who focus on dividends are often better served by the DCF because it includes predicted dividend levels in the assessment of likely returns. The risk premium method does not.

References

• Worldbank.org: Equity risk premiums
• Investopedia.com: Equity risk premium