The Average Equity Risk Premium
The average equity risk premium is the amount of return on a stock that compensates the holder for the risk of the company. It is used to compute the expected return on a stock and the price.
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Computing the Average
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The risk premium is computed by taking the rate of return given by the stock market, usually the S&P 500 index, and subtracting the rate of return for a risk-free rate, usually a 90-day government T-bill. This gives you the risk premium for a single moment in time. Computing it over time and then averaging gives you the average equity risk premium.
What are the Numbers?
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The rate over more than a century has been 7.5 percent, while the recent average from 1987 through 1996 was 8.3 percent, according to a 1998 "Valuation Strategies" article on equity risk premiums.
CXO Advisory group took a different tack. In its "Equity Risk Premium From Practitioners," it polled expert financial advisers in May 2010 on what risk premium they are using to value stocks. CXO got an average of 5.1 percent.
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Using the Average
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To use this to value a single stock, you need the stock's beta, a measure of risk that can be found on some stock trading sites, such as MSN Money. Then use this formula:
Return = Beta X average equity risk premium + risk free rate
Take McDonald's (MCD) as an example. MSN puts its beta at .55, meaning that it is less risky than the market, which has a beta of 1 (Stock Market Investors). We'll use CXO's present average equity risk premium of 5.1 percent, The current 90-day T-Bill rate is .13% for 90 days or .52 percent for the year.
Return = .55 X 5.1% + .52%
Return = 3.325%
So investing in McDonalds right now would give you a return on 3.325% between dividends and increases in market price.
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