Equity Risk Premium
Categories: Company Valuation, Stocks, Insurance
See: Risk Premium.
Investing is about risk. And reward. Optimizing the marriage. That's what any boiler room meathead in a Hugo Boss suit will tell you. To be fair, you'll also hear it from business school professors and award-winning economists.
The equity risk premium (it's a number) is a semi-good way to put that old adage into numbers...to make relative calculations as to whether or not that million bucks you're paying to own 1 percent of the flying car company is a good risk-adjusted bet...or not. To start the calculations, you begin with the math of getting a certain return from virtually risk-free assets (like, say, U.S. government bonds). They pay, like...3%? 4%? 5%? Something like that in the modern era.
Then you have the stock market, which is a lot more speculative (or rather, more volatile) than government bonds. Stocks go up and down. Companies go bust. This week's hot biotech stock is next week's subject of an FDA investigation. Hi, Theranos. We're lookin' at you. That stock market risk is then way bigger than U.S. government bond risk. But if you're investing in private companies with no liquid market, then the risks are massively higher.
So how much more do you earn for taking the extra risk of buying private stocks? Or even public ones? That number is called the equity risk premium. It's the added expected return that you get from putting your hard-earned investment funds in more jeopardy by buying equities ("Equity" is another name for stocks or ownership, by the way).
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Finance: What is risk premium?0 Views
Finance Allah shmoop What is risk premium No it's not
This movie in three D risk premium comes from the
notion that when you invest in pretty much anything other
than US government debt there is more risk in that
other investment like even by the bonds of Disney or
Coke or GOOG or some other behemoth company of those
bonds carry more risk than US government paper And if
you bought the stocks I even equities not the bonds
of one of those beam off cos Well there's way
more risk Well historically stocks have swung up and down
violently in short periods over time but over long periods
of time they've gone up Ah lot Well regardless where
there is more perceived risk investors will demand more potential
reward Yeah the key idea here every investment carries more
risk than US government paper So on top of whatever
U S Government bonds air yielding investors tag on top
of them a premium investment return that they require to
be interested in investing So if say a five year
U S Government bond is yielding three percent and you're
looking at investing in bonds backed by a controversial low
warlord Somalian company Well there's at least some tangible risk
of bankruptcy there right Well then those bonds will carry
meaningful E a higher yield than the US government five
year paper If the risk that the company doesn't pay
back its bond is modest well then maybe that premiums
only one percent on top and those five year bonds
yield in a four percent If the risk is big
they might have to yield eight or ten or fourteen
percent or more But those were extremely high rates at
least these days The market's telling you that the company
and backing the money already has one foot in the
grave So now let's go to a completely different way
of thinking about this extra risk your local diner Think
of our risk free five year U S Government bonds
of yielding three percent and being priced like a dinner
salad which is the cheapest item on the menu right
here So everything else will cost more than that salad
crew tones included So then when you're ordering if you
wanted a burger it's total gross Cost is seven bucks
But you could also describe that cost to the angry
waitress or friendly robot as dinner salad plus four bucks
The premium tacked onto the salad price is four dollars
for the burger Well risk is priced and described the
same way there has to be added investment return to
reflect the added risk to the investor on any given
deal Be careful though There's inherent risk even if all
you do is order to the salad Especially if there's
been a romaine lettuce E Coli warning recently issued by
the CDC And you do not want to go there 00:02:32.288 --> [endTime] My God