The equity risk premium is an important key figure in the field of business valuation. It is used to calculate the additional return that an investor requires for assuming market risks. But how can this premium be reliably determined and what impact does it have on the valuation results? In this article, we address these questions and show why the equity risk premium is of central importance for auditors or heads of accounting at corporate groups.
To understand why there is an equity risk premium, you can make a simple comparison between a safe investment, such as a savings account, and a riskier investment, such as a share.
While the share promises the chance of a higher profit, it also harbors the risk of losses. The equity risk premium is basically the additional return that an investor requires on average to take on this risk of loss.
Put simply, the equity risk premium expresses the difference between the expected return on a risky investment on the stock market and the return on a risk-free investment.
The CAPM provides a formula for calculating a company's cost of equity. These are made up of the risk-free interest rate and the company-specific risk premium:
Risk-free interest rate: This is the return on a risk-free investment, such as a long-term government bond.
Risk premium: This consists of a price component and a quantity component. The price component reflects the additional return that investors demand on average for holding a share.
The quantity component is expressed by the beta factors. It measures how strongly the return on a share moves in comparison to the market as a whole. A high beta factor means a high sensitivity to market fluctuations and therefore a higher risk.
The equity risk premium is therefore the price that investors demand for assuming additional risk. It is a key parameter in the CAPM because it has a significant influence on the cost of equity. The higher the equity risk premium, the higher a company's cost of equity.
The importance of the equity risk premium for business valuation is correspondingly high.
The equity risk premium cannot be measured directly, which is why indirect methods must be used to determine it. These include the historical or implicit equity risk premium, and surveys are also conceivable. It should be noted that each of the approaches has its advantages and disadvantages and is suitable for different purposes:
The historical equity risk premium is calculated as the average difference between the returns of a broad market index (such as the DAX or the S&P 500) and a risk-free investment (for example a ten-year German government bond) over a certain historical period.
The advantage of this process lies in its simplicity. The calculation requires only a few assumptions and is based on real data. However, the past is by no means a reliable indicator of the future. This is because market conditions can change and historical data can be distorted by extraordinary events such as financial crises.
The implied equity risk premium is derived from the current prices of options. Option models make it possible to calculate the implied volatility, which in turn allows conclusions to be drawn about the expected equity risk premium.
While the advantage of this approach is to look ahead and take into account current market conditions and investor expectations, there is also a disadvantage: the calculation is significantly more complex and assumption-heavy, and it also depends on the quality of the option data.
As already indicated, there is no uniform, generally applicable equity risk premium in practice. Institutes such as the IDW/FAUB (Institut der Wirtschaftsprüfer/Forschungsinstitut für angewandte Betriebswirtschaft - Institute of Auditors/Research Institute for Applied Business Administration) do provide guideline values, but these tend to represent a range. Currently, an equity risk premium of between 6% and 8% is often assumed.
The reason for this fluctuation lies in the complexity and uncertainty associated with determining the equity risk premium.
Various factors have a significant influence on this range. For example, a general market situation with high volatility usually leads to a higher expected return and thus to a higher equity risk premium.
The specific characteristics of a company are also important: companies in different sectors and with different business models generally have different risk profiles.
The choice of calculation method also plays a decisive role, as different approaches can lead to different results.
Auditors are generally familiar with the common valuation methods and can advise companies on the selection of the appropriate equity risk premium. In addition, leading international experts such as Prof. Aswath Damodaran regularly publish studies and articles on determining the equity risk premium.
The equity risk premium is central to business valuation. It reflects the additional return that investors demand for assuming market risks and has a significant influence on the cost of equity of a company.
However, determining the equity risk premium is challenging and subject to considerable uncertainty. Various factors such as the general market situation, the specific characteristics of a company and the chosen calculation method have a significant influence on the result. Therefore, there is no uniform, generally applicable equity risk premium.
In practice, there is often a range of possible values for the equity risk premium. This enables the user to select a suitable figure for the company in question. Auditors and other experts play an important role here by supporting companies in selecting the appropriate method and interpreting the results.
We support you in researching the data — e.g. putting together the peer group — with a short training session on how to use the platform. We are happy to do this based on your specific project.
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