In equity valuation, three key concepts often create confusion for investors: beta, the equity risk premium (ERP), and the company-specific risk premium (CRP). Together, these drive the cost of equity, which directly impacts how we value stocks.
1. Beta – Market Risk
Beta measures a stock’s sensitivity to the overall market. If the market goes up by 1%, a stock with:
Beta > 1 usually rises by more than 1% (more volatile than the market).
Beta < 1 usually rises by less than 1% (less volatile than the market).
Beta ≈ 1 tends to move in line with the market.
Important: Beta captures systematic risk (linked to the market), not company-specific problems. A stock can underperform massively over 5 years and still have a beta above 1 if it tends to move sharply with market cycles.
2. Equity Risk Premium (ERP)
The ERP represents the extra return investors demand for holding equities over risk-free government bonds. For India, this might be 6–7%, while the risk-free rate (10-year government bond) might be ~7%.
If beta is 1, the investor expects roughly:
For example, if risk-free = 7%, ERP = 6%, beta = 1:
3. Company Risk Premium (CRP)
Beta and ERP alone often underestimate risk, especially in emerging markets or company-specific crises. This is where CRP comes in: an additional premium investors demand for risks not explained by market correlation.
Examples of CRP triggers:
Governance concerns
Asset quality deterioration
Management credibility issues
Sectoral disruption or regulation shocks
Thus, the adjusted formula becomes:
4. Example: IndusInd Bank’s Crisis
IndusInd Bank has historically traded at a healthy price-to-book (P/B) multiple due to high Return on Equity (ROE) and growth. But during crises (asset quality fears, whistleblower allegations, exposure to risky borrowers), three things happened simultaneously:
CRP increased – Investors demanded a higher premium because of uncertainty about loan quality.
ROE expectations fell – Credit costs rose, reducing the bank’s profitability outlook.
Valuation multiples contracted – P/B fell from ~3x to ~1x as the cost of equity went up and expected earnings went down.
This dynamic explains why a bank like IndusInd could underperform massively versus Nifty over five years, not because of a low beta, but because of higher company-specific risk.
5. Putting It All Together
Beta: Measures volatility vs. market, but doesn’t capture company crises.
ERP: Market-wide premium for holding equities.
CRP: Extra compensation investors require for company-specific risks.
Why this matters for valuation:
When ROE > Cost of Equity, investors are willing to pay higher valuation multiples.
When ROE < Cost of Equity (after crises), multiples compress sharply.
Key Takeaway
Relying only on beta to measure risk can be misleading. True cost of equity should reflect not just market sensitivity (beta × ERP), but also company-specific risk premium (CRP). This is why a stock like IndusInd Bank, despite showing moderate beta statistically, deserves a much higher cost of equity in practice when sentiment and fundamentals are under stress.
Numerical Illustration: Impact of CRP and ROE
let’s anchor this to realistic market multiples that IndusInd Bank actually traded at:
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Jan–Feb 2024 (pre-crisis): ~2.0× P/B
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Now (1.5 years later, post-crisis): ~0.9× P/B
We’ll show how this can be reconciled using the justified P/B formula:
🔹 Pre-Crisis (Jan–Feb 2024)
Let’s assume:
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Risk-free = 7%
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ERP = 6%
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Beta = 1.1
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CRP = 0% (confidence was high)
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Cost of Equity = 7% + (1.1 × 6%) = 13.6%
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ROE (expected) = 17%
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Growth (g) = 9%
This is close to the observed 2.0× P/B, which suggests that the market was pricing IndusInd as a high-ROE, high-growth franchise with low perceived risk.
🔹 Post-Crisis (Now, ~1.5 years later)
Changes after crisis:
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CRP increases by +3% due to asset-quality fears
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Cost of Equity = 7% + (1.1 × 6%) + 3% = 16.6%
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ROE expectations fall to ~12% (due to higher credit costs, slower loan growth)
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Growth slows to g = 7%
This is lower than the current 0.9×, but directionally consistent: once risk premium goes up and ROE expectations fall, justified multiple compresses sharply.
🔍 Why Market Shows 0.9× Instead of 0.5×
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Investors may be pricing in partial recovery (ROE could bounce back to 13–14% in 2–3 years).
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CRP may shrink if clarity emerges.
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So instead of pricing for the worst case (0.5×), the market balances current uncertainty with future recovery → ~0.9× P/B.
This simple calculation shows how:
Even with the same beta, the increase in CRP and fall in ROE sharply reduce the justified valuation multiple.
Investors reprice the stock downward, reflecting higher perceived risk and lower profitability.
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