Valuing a business by discounting its cash flows? Guess what’s lurking in the discount rate. Yep, the renowned equity risk premium. Better yet, business appraisers like to drop a formal name for this number – the implied equity risk premium. What is going on?
Well, to start with, take a look at the way the discount rate is built up. Note that, in addition to the usual risk free rate of return, there are the so-called risk premia. Why all these additional risk parameters? Because owning a private business is much more risky than putting your money into risk free investments such as the US Treasury bonds. Uncle Sam is known for its ability to pay off its obligations, i.e. the interest and principal of the bonds the government issues.
Things may not look as rosy when you invest in a small company. The market is littered with memories of once successful businesses going belly up and reneging on their obligations. So there is extra risk you as an investor may not see all or part of your expected returns. And the business risk does not end with disappointing returns on investment. You may lose your entire investment if the company fails.
One of the key elements of this additional business investment risk is the equity risk premium. It does not belong to any particular company, rather the business market as a whole. In other words, no matter what companies you put your money in, you run the extra risk compared to the safe haven of the US Treasuries.
What’s the story behind the implied risk premium name? The key model used to calculate this premium, abbreviated as ERP, is to use the discounted cash flow formula. Surprised? Don’t be – using the DCF methodology to calculate the equity risk premium actually makes sense.
Here’s how it works. First, you pick a market index broad enough to represent the equities market as a whole. A good choice of the market barometer is the Standard and Poor 500 index which comprises a number of industry bellwethers playing a major role in the free market economy. The index spot price is publicly known and you can look it up in a heart beat.
Next, you estimate the cash flows expected to be thrown off by the S & P 500 index over some time in the future, say 5 years. At the end of the forecast, make a guess as to the long-term earnings growth rate by checking the market analysts’ consensus.
Now you have all the inputs you need to construct a discounted cash flow model. On one side of the formula you have the current S & P 500 index price. On the opposite side, you have the discounted cash flow formula with your cash flow forecast and the terminal value.
The discount rate is the only unknown you need to figure out. But since the DCF model above cannot be solved directly for the discount rate, you need to run a series of guesses until both sides of your model are equal to each other.
In other words, you search for a suitable discount rate in an implied manner. Your college math professor would call it an optimization search. You stop your search when your discount rate guess gives you the equality above.
Now, the discount rate you get contains both the risk-free rate of return you already know and the equity risk premium, or ERP. A simple subtraction gets you the equity risk premium number.
Since you are looking at the equities market as a whole, no other risk premia are included in your result. So once you are done calculating the ERP, it is time to gather the info on the additional risk elements your business faces. These vary depending on your industry sector, company size, or any company specific risks you anticipate.