Valuation : Question 14
Is the government bond rate really the floor rate? In your view, what is the most appropriate method for calculating the risk premium on equity markets? Can you find the calculation of the discount rate on the internet?

Yes, when calculating the rate of return required by investors, you should use the 10-year government bond rate as the risk-free rate. A government-backed guarantee, in developed countries at least, is the best you can hope to get on the market. You should take a long-term rate to discount flows on shares over a long period.

There are two methods for calculating the risk premium of the market, which yield a historic premium or an anticipated premium.

The historic risk premium is calculated as the difference between returns on the equity market and the risk-free rate observed over a very long period (at least 25 years, and sometimes 100).

The anticipated risk premium is determined by observing existing share prices and anticipated dividends. We then get the rate of return that is required implicitly by shareholders today. By subtracting the government bond rate and then dividing by the share’s beta, we obtain the risk premium that is currently required.

This second method is more satisfactory as it yields a current value for this premium and not an average of previous values.

Obviously you won’t be able to go off on your own and do these two calculations as they are complex and rely on a large number of data.

Specialised firms and banks do these sorts of calculations on a regular basis.

For more information, see chapter 19 of the Vernimmen.