How to Calculate Risk Premium: Definition & Formula

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  • 0:03 Risk and Reward
  • 1:16 The Needed Variables
  • 3:35 Calculating the Risk Premium
  • 4:28 What Does it All Mean?
  • 4:54 Lesson Summary
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Lesson Transcript
Instructor: Adam Gifford

Adam holds an MBA and a MS in Human Resources

When people invest in the stock market, they generally expect to get paid more money for taking greater risks. This is known as the risk premium. In this lesson we'll define and learn how to calculate risk premium.

Risk and Reward

Melissa and Alan both have money that they want to invest. Melissa is a bit more conservative in her investments because she's afraid of losing money with her investments. She has decided to make a lower risk investment in a company called Spotless Pool Cleaning. Alan is more aggressive and hopes to make a lot of money with his investments. He has decided to make an investment in a company called Quick Apps. Luckily for Melissa and Alan, there are different types of investments that have different levels of risk.

In investments, risk is defined as the possibility that an investment could possibly lose money. In order to entice people to invest in something with a higher risk, there must be a greater financial reward for making that investment. This financial reward is called the risk premium. The risk premium is defined as the payout to an investor that's greater than the risk-free payout.

A risk-free payout comes from an investment that doesn't have any risk of losing value. This generally has a very low payout as compared to an investment that does have risk. Without this greater payout, there would be no reason for Alan to put his money in a riskier investment. The increased reward is what motivates Alan to take the risk of possibly losing money.

The Needed Variables

There are two variables that are needed in order to calculate the risk premium of an investment:

  1. The estimated return on an investment
  2. The risk-free rate

There are two methods than can be used to estimate the return on an investment:

The dividend-based approach:

This is calculated by adding the dividend yield and the growth in dividends. A dividend is a cash payment made by the investment to the owners of the investment.

  • The dividend yield of an investment is the percentage of the investment value that's paid out in cash. If an investment is worth $100,000 and has a dividend yield of 5%, then the total dividends will be $5,000.

  • The dividend growth of an investment is the amount that the dividend has increased over the course of a year. If an investment has a dividend of $100 last year and $105 this year, the dividend growth is 5%.

Both the dividend yield and dividend growth are determined by the owners of the investment. These numbers can be changed by the owners in order to make an investment more attractive to more investors.

Let's look at an example of this calculation. Melissa's investment in Spotless Pool Cleaning has a dividend yield of 4% and dividend growth of 2%.

  • Return on Investment = Dividend Yield + Dividend Growth
  • Return on Investment = 4% + 2%
  • Return on Investment = 6%

The earnings-based approach:

This is calculated by dividing the investment's earnings per share (abbreviated as EPS) over the past year by the current market price of the investment.

  • Earnings per share is a measurement of how much money an investment earned per unit of ownership.

Now, we'll look at an example of this calculation. Alan's investment in Quick Apps has an EPS of $2 and a market price of $50.

  • Return on Investment = EPS / Market Price
  • Return on Investment = $2 / $50
  • Return on Investment = .04
  • Return on Investment = 4%

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