10 months have passed since the global outbreak of the Covid-19 pandemic and in that period, much has changed in the equity market. Therefore, we decided to present you with an update of equity risk premiums for Croatia and Slovenia.

10 months have passed since the global outbreak of the Covid-19 pandemic and in that period, equity markets have been a roller coaster. In Q1 of 2020, the outbreak of Covid-19 has had a negative impact on the macroeconomic prospects, global capital markets and introduced additional risks to virtually every listed company. In other words, Covid-19 has undoubtedly influenced the estimates for future cashflows, growth and risk and therefore the intrinsic value of the regional companies.

However, since the early outbreak much has changed, such as the unprecedented fiscal and monetary stimulus coupled with the development of the vaccine. All of the mentioned gave additional tailwind to the markets, resulting in a partial rebound in equities in the region.

For today, we decided to present you with an update of equity risk premiums for Croatia and Slovenia. In short, the equity risk premium (ERP) can be explained as an excess return an investor would demand to invest in the average equity over the risk-free rate.

The equity risk premium can be seen as a function of:

• how risk averse the investors are (premium increasing with risk aversion)
• how much risk is perceived in the investment (premium higher for riskier investments)

According to Damodaran, to estimate the equity risk premium for a country, one should find the premium for a mature market and add an additional country risk premium, based upon the risk of the country in question. To estimate the mature market risk premium, one has to compute the implied equity risk premium for the S&P 500 index. This is done by calculating the implied expected return on stocks which is then deducted by the risk-free rate (T. Bond rate).  

Historical ERP for Developed Markets (1961 – January 2021)

Source: Aswath Damodaran, InterCapital Research

As of January 2021, the ERP for a mature equity market (such as the USA or Germany) amounts to 4.72%, representing a solid decrease of 1.4 p.p. since our update in April 2020. The current ERP is somewhat higher than the historic median of 3.94% (since 1961) and is closer to the average of 4.21%. When looking at the table below, one can also indicate that the equity risk premium for the US is very much in line with the historic data based on a few different time spans.  

Historical ERP for Developed Markets

Source: Aswath Damodaran, InterCapital Research

In order to calculate the equity risk premium for Croatia or Slovenia, one would, according to Damodaran, have to add an additional country risk premium to the premium for the mature market. Damodaran calculates the country risk based upon the local currency sovereign rating for the country from Moody’s or with the CDS spread for the country (if one exists and/or has sufficient liquidity to be representable). Another way to estimate country risk would be by calculating the spread of the country’s EUR denominated 10 year bond and the Bund, since Bund is deemed as default free. We believe that this the most current metric as it reflects an up-to-date opinion of wide investor universe over the perceived default risk of Croatia and Slovenia.

Spread Between 10Y Croatian/Slovenian Government bonds vs Bund

 Source: Bloomberg, InterCapital Research

As visible from the graph above the spread between Croatian 10Y EUR denominated bond and Bund currently stands at 1.24%, while the Slovenian one is at 0.46%. This is somewhat lower than the median of 1.59% and 0.55%, respectively. Meanwhile, during the outbreak of the pandemic the spread reached as much as 2.68% and 1.4%, respectively, which was tamed by an unprecedented monetary stimulus in the EU. According to Damodaran, to compute the country risk premium it makes sense to adjust the above-mentioned default spread by the relative equity market volatility for that market. The multiplier amounts to 1.1 according to Damodaran.

Finally, we reach the ERP for Croatia which, as of January, stands at 6.07%. Meanwhile, Slovenia’s ERP stands at 5.23%. This represents a decrease by more than 2 p.p. for both ERP’s compared to April 2020, when they reached their 2020 peak.

In the graph below you can find the ERP for Croatia and Slovenia since 2018. As visible from the graph both ERP’s are currently at one of the lowest levels in the observed period. To be specific, Croatia’s ERP is lower by 1.1 p.p. compared to the median of the period, while Slovenia’s ERP is lower by 0.7 p.p.

Croatia’s and Slovenia’s ERP (2018 – Jan 2021)

Source: InterCapital Research

We once again note that when calculating the cost of equity for Croatian or Slovenian blue chips, the same (above state) ERP should not always apply based on the country of incorporation. Many of these companies have a significant portion of their operations outside of the country of their incorporation and the risk of operating there should be reflected in the ERP. This can be done by weighting the ERP based on revenues (or another key performance indicator) it makes in each country it operates. By doing so, we believe that we estimate a more accurate ERP, without over/underestimating the risk premium with regards to operations in foreign markets. Intuitively, if a company operates in markets which are perceived to have a higher country risk premium than the one of incorporation, it’s ERP will be higher. For example, Slovenian financials operate in almost all Ex-Yugoslavian countries which all have a higher perceived country risk premium than Slovenia. Therefore, the ERP for these companies should be higher than the one above stated.