India Equity Risk Premium 2021 Independent valuation services

Since risk aversion varies across individual investors, it is the collective risk aversion, which determines the movement in equity risk premium. Further, the expected return on equity is equal to the risk-free rate plus a risk premium that investors demand for taking additional risk by investing in equities. Since risk-free rate is observable, implied ERP can be computed as residual of expected return on equity (ke) and risk-free rate (Rf). Against this backdrop, this article attempts to decompose equity price movements in India since 2005 to 2020 into contribution of changes in growth expectations, interest rates and Equity Risk Premium (ERP) using DDM.

1. During the year, financial results of listed companies also turned out to be better than feared, driving significant upgrades to earnings estimates for FY23—a rare occurrence, given that over the past decade, earnings estimates have tended to get revised down.
2. In this issue, we have expanded the coverage of historical ERP to both Sensex and NIFTY50 indices.
3. In my view, the biggest problem with ratings agencies is not that they are biased, but that they take too long to adjust ratings to changes in a country and that they sometimes underrate or overrate regions of the world, because of their histories.
4. Signals on end-demand growth globally have been distorted by supply-chain disruptions and bull-whip effects for major inputs like steel.
5. ERP is influenced by multiple factors, such as, risk-profile of investors, volatility in markets, etc.

This is largely consistent with the divergence between real economy and market observed in 2019 wherein ERP stayed low contributing to surge in equity markets to record-highs and GDP growth stayed muted. Overall, while the ERP has stayed below 4 per cent levels https://1investing.in/ since 2016, real GDP growth has remained below 2016 level which was 8.7 per cent. ERP is conceptualised as the excess return that makes an investor indifferent between holding a risk-free investment, usually a government bond, and a risky equity investment.

Musings on Markets

We can think of the risk premiums calculated in the two approaches this way – Approach 1 is the premium that Indian investors are currently demanding from equities whereas, Approach 2 is the premium that investors should be demanding from Indian equities. That is, the equity risk premium india premium in Approach 2 is a more fairer reflection of the risk inherent in the Indian markets given the returns available elsewhere in the world. Prof. Damodaran discusses various ways of computing default risk in his paper on risk free rates and country risk[ii].

Royal Dutch may be a UK (or Dutch) company, in terms of incorporation and trading location, but it extracts its oil and gas from some of the riskiest parts of the world. Since country risk is multidimensional and dynamic, my annual country risk update runs to more than a hundred (boring) pages, but I will try to summarize what the last year has brought in this post. Global inflation, and in particular US inflation, is definitely something that can be a risk, if nothing else because of uncertainty. US inflation is at levels not seen for many decades, and very few of current market participants have the experience of operating in such markets. Given that the US treasury yield has been the anchor for valuation of most assets globally, and if they rise rapidly, they can destabilize several market assumptions that have not been tested for a decade.

With the long lead in on the dimensions of country risk, we can now turn to the more practical question of how to convert these different components of risk into country risk measures. We will start with a limited measure of the risk of default on the part of governments, i.e., sovereign default risk, before expanding that measure to consider other country risks, in political risk scores. As you assess these factors, you can see very quickly that country risk is a continuum, with some countries exposed less to it than others. It is for that reason that we should be cautious about discrete divides between countries, as is the case when we categorize countries into developed and emerging markets, with the implicit assumption that the former are safe and the latter are risky.

Guangye Cao & Daniel Molling & Taeyoung Doh, (2015) “Should monetary policy monitor risk premiums in financial markets? One of the most popular ways to value a listed company is to run a discounted cash flow (DCF) valuation. For this method, you estimate the future cash flow of a company and discount them back to the present using a discount rate.

A Critical Review of the Implied Cost of Equity: A New Way to Estimate the Expected Return

ERP is influenced by multiple factors, such as, risk-profile of investors, volatility in markets, etc. Assessment of equity prices may also help to identify financial imbalances or risks in an economy as it contains information about the degree of uncertainty around the economic outlook. The analysis of equity prices and understanding of the drivers of change in equity prices assumes significance as it interacts with monetary policy and could have different implications for policy actions. The negative coefficients of increase as well as decrease in ERP establish the inverse relationship between economic activity indicators (IIP and GDP) and equity risk premium. However, both the regression results suggest that while the increase in ERP assumes significance in explaining the dependent variables, i.e., IIP and GDP, decrease in ERP is insignificant in line with the economic theories.

We are pleased to release the third edition of Incwert’s holding company discount (“HoldCo Discount”) study 2022, based on the analysis of select listed holding companies across major sectors in India. We observe that the median HoldCo discount in FY22 is approximately 71 per cent across the major listed holding entities in India. Now if we get 3% as India’s Country Risk premium and 5% as the US ERP then India’s Equity risk premium will be 8%.

In this issue, we have expanded the coverage of historical ERP to both Sensex and NIFTY50 indices. A detailed cross-section of the value of ERP is presented in this report, allowing a user to choose the time frame as deemed appropriate. While the global aggregate value for 2022 is very similar to the value in 2021, there has been a significant drop off since 2016, at least according to this measure. In 2022, North America and Western Europe scored highest on the democracy index, and Middle East and Africa scored the lowest. The reason for using this proxy is that the actual payout ratio[iv] of Nifty 500 is low at about 34%.

Again, there are subjective judgments at play in these measures, but the map below gives you 2023 scores for peace scores, with lower (higher) scores indicating less (more) exposure to violence. We can take the above concept and apply it to stocks to calculate an implied equity risk premium. Signals on end-demand growth globally have been distorted by supply-chain disruptions and bull-whip effects for major inputs like steel. Our work suggests that end-demand, both consumption and investment outside the US is weaker than what some of the supply-constraints indicate, and this would become clearer once supply has responded to the price signals.

Why is there a difference between the two approaches?

This discount rate known as Cost of Equity or Cost of Capital is calculated usually using a model called CAPM and one of the most important variables of the model is the Equity Risk Premium. In my view, the biggest problem with ratings agencies is not that they are biased, but that they take too long to adjust ratings to changes in a country and that they sometimes underrate or overrate regions of the world, because of their histories. Consequently, Latin American countries have to work harder to improve their ratings, or sustain current ratings, than the US or European countries, which get a bye, because they do not have a history of default. Accordingly, the lower premium in Approach 1 implies that Indian investors are charging too less a premium given the expected returns which are available elsewhere. However, since Indian investors cannot easily invest outside India, they are likely to stay invested in Indian equities thereby not letting the markets correct enough to merge towards a more fairer value of the risk premium.

In this edition, we have analysed the Equity Risk Premium (ERP) as of the cut-off date of 31 December 2018. We hope to provide useful insights to investors and professionals in their decision-making process. 1 Free cash flow to equity (FCFE) is the amount of cash a business generates that is available to be potentially distributed to shareholders. In other words, FCFE is the cash left over after taxes, re-investment needs and debt repayments. Since we can observe stock market booms and busts in the past, this drawback is not insignificant. Once we have this number we need to subtract it from the 10-year bond to get a real risk free rate.

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In my discussion so far, you will notice that I have stayed away from talking about currency risk in my equity risk premium discussion and from currency choices in investment analysis. Before we delve into the equity risk premium , lets first deal with country risk and why it is required to be computed. While there is agreement among investors and corporate finance professionals alike that a higher return is expected from investments in equity securities, there is subjectivity around the estimation of such premium. This quantification is further obscured by insufficient data and studies on the topic in emerging economies such as India.

Similarly, equity prices might be falling not only because of weak growth prospects but may be due to rise in ERP. Embraer, the Brazilian aerospace company, and Tata Consulting Services, an Indian software company, would be good examples. Conversely, there are developed market companies that are significantly exposed to country risk, either because of where they produce (Royal Dutch) or where they sell their products and services (Coca Cola). For multinational companies, an operating risk perspective will imply that there can be no one hurdle rate across geographies, since a project in Turkey should require a higher equity risk premium (and hurdle rate) than an otherwise similar project in Germany. In addition to capturing risks that go beyond default, Political Risk Services also measures risk scores for frontier markets (like Syria, Sudan and North Korea), which have no sovereign ratings. The minuses are that the scores are not standardized; for instance, PRS gives its highest scores to the safest countries, whereas the Economist gives the lowest scores to the safest countries.

So for example, if the Indian 10-year bond is giving us 6.2% and the probability of default is 1.5% then the real risk-free rate is 4.7%. That is, 8.06% is the return that is required to make the present value of the coupons and redemption value equal to the current market price of the bond. Things get even more complicated when you recognize that these drivers are often correlated with, and drive, each other. Thus, a country that is ravaged by war and violence is more likely to have a weak legal system and be corrupt. Furthermore, all of these risk exposures are dynamic, and change over time, as governments change, violence from internal or external forces flares up. Dison, Will and Rattan, Alex (2017), “An improved model for understanding equity prices,” Bank of England Quarterly Bulletin, Bank of England, vol.