Are you mispricing investment risk?
Given the volatility in forward-looking equity risk premium (ERP) estimates, CFOs should have their financial planning and analysis team assess and estimate a forward-looking ERP and cost of capital on a more frequent basis (at least quarterly).
In a Tale of Two Capital Markets, a Deloitte CFO Program study, we noted corporate strategy was being redefined by the differentiated costs of capital. Some global companies with strong balance sheets are able to access capital at costs in the 2% to 3% range, while others pay substantially more (over 7%), if they are even able to access fresh capital. But, those with inexpensive costs of capital must be careful not to misprice the costs of investment risks, and invest in assets without accounting for what equity holders expect as a return.
Since the 2008 financial crisis, however, we have found that managers sometimes do not fully account for the dynamic and variable nature of equity risk premiums (ERP) when estimating a cost of capital and evaluating potential investments.
In this issue of CFO Insights, we discuss the nature of ERPs in the current environment and how volatility can affect those calculations.
CFO Insights: Are you mispricing investment risk?
What is an equity risk premium?
In the standard capital asset pricing model, underlying the valuation of assets:
The Expected Return on the Equity = Risk Free Rate of Return + (Beta of the Asset * Equity Risk Premium).
Here the ERP is the premium investors expect above the risk free rate of return for investing in a broad portfolio of equities or an average risk investment. Thus, the ERP is fundamental to evaluating most investments and in framing the minimum expected return for an investment. What we have found, as have others, is that companies often tend to use a static ERP, one that does not account for the volatility of markets today and investor expectations for risk.
Implications of ERP volatility for CFOs
The dynamic nature of ERPs over the last few years may put companies at risk of inappropriately evaluating potential investments. To address this, CFOs should re-examine how investments are typically valued using the following steps:
- Dispense with the myth of the static ERP.
- Decide how to estimate ERPs on an ongoing basis.
- Recognize that ERP varies by country markets.
- Recognize that ERP varies by industry.
The dynamic ERP imperative
In addition to the above reasons for developing and adopting a more dynamic approach to estimating forward-looking ERPs, CFOs today have added reasons to attend to this issue. First, in recent years, U.S. and international accounting standards have been increasing the need for fair value estimates. Second, boards and managers involved in mergers and acquisitions require an appropriate estimation of the cost of capital in evaluating deals.
Download the full CFO Insights article, Are you mispricing investment risk?, at the top of this page to learn more.
As used in this document, 'Deloitte' means Deloitte LLP. Please see www.deloitte.com/about for a detailed description of the legal structure of Deloitte LLP and its subsidiaries. Certain services may not be available to attest clients under the rules and regulations of public accounting.