Would you consider those that invest in stocks to be out of their mind? Investors provide companies with important funding but get no guaranty in return. There is no guaranty on profit, and if things go south, investors can lose all of their cash. This is also the main reason stocks are risk capital.
So, pretty crazy, right? Not really, because of their generous provision, a company can grow through investing.
The money that companies receive by selling stock gets invested, hoping these investments -albeit a few years later- get earned back twice or even more.
Thus, investing in stocks is not purely speculative as some are suggesting. For companies, this stock capital is what water is to life. Without this basic financing, we wouldn’t have companies.
Some companies become world leaders in their field and multiply their capital year after year. At least, a part of that extra profit almost always goes to the shareholder in the form of dividend payout. Additionally, the company becomes more valuable thus increasing the stock price.
The difference between bonds
That is the significant difference between stocks and bonds. Equity capital is the ‘equity’ of companies, (bond) loans are ‘borrowed capital’. It’s in the naming: the temporary foreign (borrowed) money must – together with a fixed interest – always be repaid, it’s a long-term debt. Whether the company does well or not, it doesn’t matter. That’s where it stops for bondholders.
A shareholder is fully involved in the difficulties of his company. If it goes bad, but also if it goes well. The difference between the extremes can be, well, extreme. Due to this uncertainty, share prices fluctuate much more than bonds. But in the end, shares yield a lot more.
In part 2, it became clear that stocks have an average real return of 6% since the 1900’s compared to a 2.4% for bonds. So, you could say that the risk premium or additional income is 3.6% on average per year for stocks.
How much the risk premium is, can only be determined afterward. However, we can make estimations. After all, that premium is the difference in yield between bonds and the profits of the company behind the share.
Share price vs profits
You can determine the “profit” of bonds quick and simple: The interest on the loan amount. Today a government bond yields less than 1%. A bond investor, therefore, receives less than 1 euro on an investment of 100 euro.
The profits of shares can go in all directions and is therefore much more difficult to estimate. It’s also connected with the evolution of the company’s profits and the price evolution of the share.
A valuable indication is the current exchange rate versus the profit of the company. Today shares are listed at around 15 times the current annual profit on average. The investor will receive an underlying annual profit of EUR 6.67 for every EUR 100 that he holds in equities (100 divided by 15). That is a theoretical earnings yield of around 6.7 percent.
Knowing the above, you can easily calculate that the risk premium for stocks today yields roughly 5,7%. That is the earnings yield of 6,7% minus the 1% of bonds.
The risk premium or remuneration for the equity risk still seems interesting today, which does not detract from the fact that a correction seems imminent.