Financial services: pricing the risk of equities and long-term debt

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When benchmark interest rates spiked, the cost of capital soared. But were these hurdle rates higher than expected in an era of monetary tightening?

The answer lies in understanding both the “term premium” and “equity risk premium”. Respectively, these compensate holders of longer-term government bonds and riskier stocks.

These two premiums cannot be officially observed but merely estimated and argued over. After short-term government bond yields rose to levels not seen in over a decade, the conceptual debate is intriguing.

According to the capital asset pricing model, a firm’s cost of equity is an equity risk premium added to a risk-free rate. The latter rate used is, typically, the 10-year US Treasury yield.

The term premium for the 10-year Treasury — the difference between owning a 10-year bond against buying a one-year Treasury in 10 consecutive years — turned positive in 2023. This had not occurred previously since 2017. That positive premium probably reflected worries about the state of the US economy a decade from now.

The equity risk premium (ERP) is more subjective. ERP is usually defined as the excess return, above the 10-year Treasury yield, an equity investor requires to hold a portfolio of stocks. There is a debate around how often an ERP needs to be refreshed. Historically, investors often relied on a long-term average of this spread. But there is substantial evidence that risk premia varies over time.

Corporate finance consultants use ERP quarterly data which has ranged between 6.75 per cent and 5 per cent since 2016. The widely-cited valuation scholar Aswath Damodaran’s data shows the equity risk premium in a range from 4 per cent to 5 per cent since 2000.

Adjusting discount rates by 100 or 200 basis points can be pivotal in capital allocation decisions. A major part of this calculation is precast within the risk-free rate. The rest depends upon subjective judgment and artistry. Its accuracy can only be evaluated after the fact.