Understanding equity risk premium and impact on valuations

Why does equity command a risk premium. Let us look at it the other way. Why do investors expect higher returns on equity than on debt. Simply, because debt is risk free and equity is not. That is too simplistic a statement. Not all debt is risk-free and even the most risk-free debt is not entirely risk free. Let us understand this better with levels of risk and the return expectations..
 
Level 1 - Government Treasury Bills : These are the most risk free in every sense of the term. Since they are backed by the government they do not have any default risk. Secondly, since they are of a very short term nature they also do not have price risk. This is normally called the risk-free rate and the yields on these Treasury Bills are the lowest.
 
Level 2 – Long Term government bonds : These entail a higher level of risk compared to government treasury bills. While long term government bonds are free from default risk they are prone to interest rate risk. That means if the interest rates go up then these government bonds, due to their long tenure, see capital depreciation. Thus price risk is a major risk in case of long term government bonds.
 
Level 3 – Corporate and Institutional bonds : Corporate bond are obviously subject to interest rate risk like in case of long term government bonds. However, these bonds do not have the  guarantee of the government and hence cannot be classified as entirely risk free. Of course, corporate bonds issued by reputed business groups will not default as they have a reputation to protect. But many mid-cap companies are vulnerable to default to risk.
 
Level 4 – Hybrid Mutual Funds : These funds combine equity and debt with a major chunk in one of them. While Balanced funds are predominantly into equity, MIPs are predominantly into debt. So while MIPs are more risky than government bonds they are less risky than balanced funds.
 
Level 5 – Index Funds : Index funds are those equity funds that just try to replicate an index like the Sensex or the Nifty. The returns on this fund will mirror that of the Nifty. This is also called a Beta fund since it only runs the market risk. The risk of an index fund is as much as the stock market as a whole. Since there is no stock selection involved here, index funds do not carry the risk of individual stocks.
 
Level 6 – Diversified Equity Funds : These are purely equity funds. They are invested in a wide array of equities and do not have any debt component. They are less risky than direct equities or sector funds because in both these cases there is the risk of concentration. Diversified funds have the advantage of professional management which makes them less risky than direct equities.
 
Level 7 – Direct Equities and Sector Funds : Both these categories of assets have concentration risk and stock selection poses a major risk in both these cases. They are therefore higher on the risk scale compared to equity diversified funds. As a result the expected returns on these funds will also be higher.
 
Why are these 7 levels so important?
 
They are important because it is these levels of risk perception that actually determine the risk premium. For the purpose of understanding risk premium let us only focus on the equity part. Here are the 4 points that you need to remember to understand risk premium..

The government securities returns can be a good approximation for the risk free rate. We are only talking about default risk and not about price risk and hence the G-Sec returns are a good approximation. That is called the Risk Free Rate (Rf)

The index fund is a good approximation for Beta or the market returns. The expected market returns will be higher than the returns on a debt fund because there are market risks involved. Interest rates could go up, GDP could fall, inflation could go up; all these are market risks over which the business does not have control. The Market Return (Rm) is nothing but the Rf + market risk premium. Therefore Rm > Rf

If you just want market returns you are happy investing in an index fund. But if you want stock selection that means you are searching for alpha. That is why return expected on an equity diversified fund will be higher than an index fund. That can be represented as Re > Rm

Direct equities and sector funds represent a concentration risk. They are betting on a particular stock or sector to do better than the other sectors. Apart from the equity risk there is also a concentration risk here. Let us represent that as Rce. You can represent this as Rce > Re.

So our final risk premium equation will look something like this..
 
                          Rce > Re > Rm > Rf
 
The differential return expectation at each stage is what equity risk premium is all about!