Risk Premium

Risk premium is basically the calculation of risk reward ratios. The risk is an uncertainty and the reward is the potential in this uncertainty. You work out your premium by- what return you are expecting from the market minus the risk free rate. So, it is an additional return over the risk-free rate earned by you for taking a risk. Generally, you use Treasury Bills (T-Bills) as a baseline to identify the risk free rate, just to simplify the risk premium calculation.



Let's take an example. If you want to purchase a well establish company called "ABC" with an expected PAT CAGR of 10% for next 5 years and you are considering a risk free rate of 6% , taking baseline from T-Bills, your risk premium will be 10%-6%=4%. And at the same time, you are also considering to purchase a new company "XYZ" with some innovative ideas but with the expected profit potential of 20%. So, in this case, your risk premium will be 14%. So higher the risk, higher will be the reward...an employee with a higher degree of risk in his job gets hazard pay for the same. Similarly, risky investments also provide a potential for large returns, whereas, companies with a long history of stable cash flow bet low risk premium than companies whose cash flows fluctuate from quarter to quarter, such as technology companies. The more volatile the company's cash flow, the more it must compensate investors.

Role of risk premium in business valuation
Risk premium is useful while valuing a business, particularly in Discounted Cash Flow (DCF) approach. This approach measure the value of the company by estimating the expected future cash flows, and then "discounting" those future flows by the buyer's desired rate of return in order to determine the "present value" of the future cash stream. This valuation method focuses on the risk-adjusted discounted stream of future cash flows.

We include two important aspects for DCF analysis: - Determining the appropriate discount rate ; and - "Residual value" beyond the short-term forecast period.

An appropriate discount rate can be derived from two factors: the "risk-free" rate of return (as with government securities, T-Bills) and "premium" over the risk free rate, for investing in the high potential but risky venture. For example, you can take minimum 8% premium over the risk free rate for a high risky business.

Residual value is estimated by the potential sale price for the business at the end of the forecast period, and then discount that sale price back to its present value to determine its worth today. We, then, sum the present values of the net cash flows in the forecast period and the present value of the residual value at the end of the forecast period to value the stock.

Risk aversion
Risk aversion is a concept where you face two situations with almost similar expected reward but with different degree of risk and you prefer to face the situation with the lower degree of risk and ready to lose out an expected higher rate of reward. If we talk about an investor in particular, risk-averse investor is the one whose portfolio is more of government bonds, index funds, bank savings rather than the high-risk stocks.

How sensitive you are for a risk?
Risk premiums are very much relevant in today' world because investors and entities are risk sensitive. Though, risk premiums are an appropriate tool for judging the worthiness of your investments but do not forget that risk and returns go hand in hand. Before making any investment, evaluate whether the risk is worth the reward you are expecting? So, in order to make balanced investment choices, you must harmonize the risk level you are comfortable with, with the expected potential from the particular investment.