Risk-averse investors demand a higher rate of return on an average equity risk investment compared to a risk-free investment. The difference in return is the Equity Risk Premium (ERP). ERP is the price of risk.
What, however, are the factors that influence the ERP?
Firm-specific risk and market risk
Finance models often make two critical assumptions about risk:
1. that risk can be defined as the variance in an equities actual returns around expected returns
2. that markets price risk from the perspective of the marginal investor
If the marginal investor is assumed to have a well-diversified portfolio of equity investments, then the investor is only concerned with the additional risk the investment adds to the portfolio. This leads to the separation of equity risk into two components:
1. Firm-specific risk: the risk specific to the investment
2. Market risk: the risk that affects most or all investments
The theory is that an investor with a diversified portfolio can diversify away firm-specific risk and so an investor is only concerned with market risk. Stock prices only reflect market risk.
If the collective investor risk aversion increases, overall investors will demand a higher ERP, and equity prices will go down. Factors that can change risk aversion include:
1. Investors age. The older you get, the more risk-averse you become
2. Consumption v saving. The ERP increases the more populations become spenders rather than savers
The more predictable the economy, the lower the risk and the lower the ERP investors demand.
Factors such as employment, consumption and growth affect economic risk.
Earnings quality and transparency
If investors perceive a decrease in overall earnings quality, then they will require a higher ERP. Reasons for a perceived decline in earnings quality include:
1. Inconsistencies between companies in how they recognise income in the financial records
2. Information overload or alternatively lack of financial transparency
Government and bureaucracy
Changes in or uncertainty about government policy can exacerbate economic uncertainty. Economic uncertainty leads to increased stock price volatility and so a higher ERP.
An unstable government and incompetent bureaucracy also drive up the ERP.
Catastrophic risk is the risk that an event can occur that causes a dramatic loss in value. The probability of a disastrous event may be low, but if disaster does strike the effect would be so severe that investors demand a higher ERP.
If on the sale of the investment, investors expect to pay high transaction costs or have to accept a discount on market prices, then they will demand a higher ERP. The investment suffers from a lack of liquidity.
Liquidity in the market changes over time, for example, liquidity decreases when economies slow or when there is a crisis. If money flows out of the equity market there is less liquidity and the ERP increases.
Simon specialises in valuing private businesses for parties involved in disputes, business buyers or sellers seeking to transact and business owners raising finance or restructuring.