Market Risk Premium Analysis

Strategy:

To standardize the market risk premium utilized by the D’Artagnan Capital fund’s analysts and managers in their analysis of individual companies weighted average costs of capital (WACC). This deeper dive should be analyzed at the beginning of each semester, thereby implemented in each individual’s valuation models for varying companies.

Directions:

  1. Take the overall geometric means for both the S&P 500 total return as well as the total yield on the 30-Year Treasury bond from January of 1927. The geometric mean is preferred as opposed to the arithmetic mean in this instance, since it measures the compound rate of change in an investment return.
  2. Subtract the geometric mean of the risk-free rate (in this case, the 30-Year Treasury yield) from the overall return of the market (geometric mean of the S&P 500 returns). This will result in the risk premium for the market.

Findings (10/2011):

Given the data from Ibbotson, the market risk premium for the S&P 500 since 1927 was 3.39%. This means that investors in the market place expect to earn 339 basis points above the risk-free rate to compensate for the additional risk of investing.