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Measuring the additional risk of equity investing

It is reasonable to suggest that investing in equities, as opposed to bonds is generally riskier due to the fact that bondholders rank above equity holders in their claim on a company’s assets.

But the question of how much compensation is due to the equity investor is the million dollar question. In this piece, I attempt to explain how the difference in this risk is appropriately measured. The ultimate objective is to enable an investor to appropriately measure the risk of an investment in the equity of a company.

In financial literature, the risk related to equity investing is called the equity risk premium (ERP). ERP is the difference in expected return between an equity index and a reference asset, typically the risk-free rate.

The ERP is used in various arrays of finance including for determining what returns to expect from each major asset class and from portfolios of securities or asset classes; in lifecycle and retirement planning; and as a component of the opportunity cost of capital or required rate of return in corporate finance. It is central to the practice of investment management and asset/liability management.

Approaches to estimating the ERP fall into three broad categories:

1. Methods based on a dividend discount model (DDM), earnings discount model, or free cash-flow model: forward-looking methods with their roots in discounted cash flow (DCF) analysis, wherein the value of an asset is regarded as the present value of the cash flows the asset is expected to generate.

2. Methods based on extrapolating past trends, in particular the spread between realised stock and bond or cash returns, into the future. These are also known as retrospective methods, which can be regarded as equilibrium model because it relies on prices at which the market actually traded, reflecting the intersection of supply and demand curves.

3. Methods based on a macroeconomic model of the way that investors require compensation for risk. The macroeconomic model is a demand model because it asks what excess return investors need to induce them to take equity risk.

The earliest estimates of the ERP are the method most widely used today, and is derived by estimating the expected return on an equity portfolio using the DDM and then subtracting the expected return or yield on the risk free asset. Typically though, this is only accurate for mature, stable, dividend paying companies, and is not appropriate for growth stocks.

Another approach used is the “Future Equals Past” approach, where the assertion is that the realised ERP was the best estimate of the expected ERP. This has become less popular in practice though due to its fundamental flaws, whereby the approach assumes that markets are fairly priced, and also that the higher the market rises, the higher the estimate of future returns, which is not appropriate thinking.

More recently, as a result of continued research (by Shiller) into the measurement of ERP, market practitioners have increasingly made use of the price-to-earnings ratio (P/Es), in particular the cyclically adjusted price-to-earnings ratio (CAPE), which smoothes earnings data by averaging them over long periods, typically 10 years.

If the CAPE or P/E of an index is 20, the real expected return is 1/20 = 5%, and one can then subtract the real risk free rate (say, 1%) to arrive at the ERP (4% in this example).

This review is not exhaustive, and many different approaches have developed over time which augment further the fundamental ways of measuring ERP, as presented above.

It is important that continued updating and studying of the equity risk premium is made as it underpins some of the most significant financial and investment decisions a person or organisation can make.

Because the ERP cannot be observed directly, it must be estimated using one of a number of indirect approaches or models.

Disclaimer: This article was issued by Simon Psaila, financial analyst at Calamatta Cuschieri. For more information visit, www.cc.com.mt. The information, view and opinions provided in this article are being provided solely for educational and informational purposes and should not be construed as investment advice, advice concerning particular investments or investment decisions, or tax or legal advice.

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