The equity Risk Premium is the difference between returns on equity/individual stock and the risk-free rate of return. It is negative in Nigeria meaning stocks will struggle to rally.
In Nigeria the risk-free rate of return can be benchmarked to the 10-year Federal Government bonds, assuming zero default risk by the government.
Essentially the equity risk premium is the excess return a stock pays to the holder over and above the risk-free rate for the risk the holder is taking.
It is the compensation to the investor for taking a higher level of risk and investing in equity rather than risk-free securities.
In Nigeria such a risk premium for equities has long vanished with the Nigerian Stock Exchange (NSE) now down 4 out of the past 5 years.
The NSE’s flagship index, the NSE ASI, returned -17.4 percent in 2015, -6.17 percent in 2016, rose +42 percent in 2017, fell by -17.81 percent in 2018 and posted a negative return of -14.60 percent for 2019.
Stocks have returned -6.35 percent so far in 2020.
The benchmark FGN 10-year bond by comparison yields 8.4 percent according to FMDQ data.
The risk free rate has fallen from a high of close to 14 percent over the past five years.
Despite the near record-low interest rates Nigerian stocks have struggled to rally.
Share prices reflect not just the expected future stream of earnings but also the rate at which the profits are discounted to present value.
Equity risk premium and the level of risk are directly correlated. The higher the risk, the higher is the gap between stock returns and the risk-free rate and hence, a higher premium is expected by investors.
The equity risk premium is a long-term prediction of how much the stock market will outperform risk-free debt instruments.
In Nigeria the premium is negative and the equation does not make sense for equity investors.
Hence stocks will struggle to rally for a while to come.