Risk Premium versus Intrinsic Value

Course: Investment Planning
Lesson 5: Fundamental Equity Analysis

Student Question:

The first review exercise page in Lesson 5, is Intrinsic Value the same as Risk Premium? Is that why we’re solving for P0 and not V (which is given)? The formula provided in the explanation confuses me. (question and answer from review exercise below)

Review Exercise Question:

1. Given the following information, what did this investor assign as the risk premium for ABC stock?

Current price of ABC stock = $25
Intrinsic value of ABC stock = $20
Last ABC dividend = $3
Risk-free rate = 3%
Dividends will remain constant

1. 12%
2. 15%
3. 7%
4. Not enough information

Review Exercise Correct Answer Feedback:

Correct.  Based on the information, you should have been able to determine that the required rate of return was 15%.

P_o  = __D_o__
              k
20 = 3/k
K = .15

After subtracting the risk-free rate, the risk premium of 12% remains.

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Instructor Response:

The risk premium is the additional return an investor demands to take on more risk that the risk-free rate of return.  For equity securities, you may see this referred to as the equity risk premium. 

A security’s instrinsic value is the theoretical value of a security based upon the net present value of its cash flows.

• To calculate NPV we must have a discount rate.
• The discount rate is equal to the required rate of return. 

I say “theoretically” because investors routinely pay more or less than intrinsic value.   For example, a market price below intrinsic value implies the security is undervalued in the market and may be a “buy signal” for investors. A market price above intrinsic value implies the opposite – the security is overvalued in the market may be a “sell signal” to investors holding the stock.

Based on the fact pattern and using our constant rate dividend model, we determine that the investor’s required rate of return is 15%.  The investor demands 12% more return than the risk free rate of 3% to invest in this security. An example of calculating required return is presented in the “Zero-Growth Model” discussion in your lesson.  From there, you would only subtract the risk-free rate to determine the risk premium.  On the CFP Board exam, a student may be called upon to calculate P ₀ ,  D ₀   or k given any two of these three variables.