Risk premium

What it means

A risk premium is the extra return an investor demands above the risk-free rate for bearing the risk of an investment. The more uncertain an investment, the higher the return it must promise for an investor to choose it over a safe government bond.

In the CAPM, the expected return on a share equals the risk-free rate plus the market risk premium multiplied by the beta coefficient, which measures the share's sensitivity to market movements. The result feeds into the WACC and thus into the discount rate used in valuation.

In business valuation, especially of smaller and private companies, further premiums are added to the market premium: for small size, country risk, illiquidity of the stake or specific risks such as dependence on one customer or on the owner.

How it works in practice

In the DCF method, the risk premium has a large effect on the result. Raising the discount rate by a few percentage points can cut the company's value by tens of per cent. Every premium should therefore be justified and documented.

In practice the market premium is taken from published studies and databases, the country premium from ratings and government bond spreads. Size and specific risk premiums require the valuer's judgement and are the most common point of debate between buyer and seller.

Risk premiums also appear in lending: the bank adds a margin to the base rate according to the client's risk. A company with weaker creditworthiness or no collateral pays more, which raises its cost of capital and lowers the return on its investments.

What to watch out for

Double counting risk is a common error. If risk has been reflected in more pessimistic cash flows, it should not be added to the discount rate as well. A valuer should state clearly where and how risk has been taken into account.

Risk premiums move with the market. In uncertain times investors demand higher premiums and asset prices fall; in good times the opposite happens. Using outdated data can seriously distort a valuation.