29 July 2018

The Market Risk Premium

Contemporary corporate finance theory says that the value of something is (a) the future expected cash flows discounted back to (b) their net present value.

by John Royden

Head of Research

By way of example, (a) £1,000 in a year’s time is worth (b) £909.09 today at a discount rate of 10%.  This is because £909.09 grows to be worth £1,000 over a year when invested at 10%. 

The interest rate and discount rate are the same sort of thing.  Interest rates are about working out what money today is worth in the future.  Discount rates are about working out what money in the future is worth today.

This theory also says that, as investments get more risky, so the discount rate should increase.  That is the same as saying that if you take a bigger risk, then you need a higher reward, when things go right, to compensate you for when things go wrong.

The rate at which investors expect to beat the risk free rate (Rf) is called the Market Risk Premium or MRP.  So according to this theory, your expected return is driven by Rf + MRP. 

If you know the future expected cash flows from a company, the share price and Rf then, with a large spreadsheet, you can work out the MRP.  We do this at JM Finn & Co every day.

Fluctuations in the MRP give us a guide as to how risk seeking or otherwise investors are.  This helps with market timing.

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