Meaning
Financial compensation required by investors for choosing the uncertainty of stock ownership over the relative safety of government bonds or cash accounts defines the cost of capital for a growing firm. Market participants calculate the equity risk premium to justify the allocation of funds to a private enterprise rather than a risk-free asset. This figure fluctuates based on the perceived stability of the economy and the specific volatility of the sector in which the company operates.
The calculation loses its relevance in scenarios of hyperinflation or total market collapse where no asset is considered safe.
Investment Return
Expected gains from a stock position must exceed the baseline interest rate by a measurable margin to attract long-term capital. Historical performance records help determine what this margin should be for a specific industry.
Risk Adjustment
Modifications to the expected return account for the specific dangers of a business model or the lack of liquidity in private shares. A dated valuation often includes a discount to reflect these factors.
Market Benchmark
Comparison with other opportunities in the same asset class allows an investor to judge the fairness of a current offer. This record of relative value guides the final decision on whether to buy or sell.
