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Wednesday, August 09, 2006

What is a Stock Worth? Part 2 – The Risk Premium

By William Trent, CFA of Stock Market Beat

In part 1 we explained that a dollar today is worth more than a dollar in the future, and showed how to calculate exactly how much more. Now we will show you how you can apply the same principle to stocks to determine how much they are worth today.

The trick is to determine how much money you are going to get in the future. With a CD you know how much you are going to get, and can be pretty sure you get it. With a bond issued by a large company, you know how much you are going to get, but it is possible the company will go bankrupt and you won’t get it – so they have to pay you more to make up for that risk.

With a stock, you don’t know much of anything. In some cases, you don’t know how much you will get, when you will get it or even if you will get it. So why would anybody in their right mind ever own a stock in the first place? Because on average stocks offer a higher return than CDs or bonds to compensate for all the uncertainty the investor deals with.

How much, you ask? By now you probably won’t be surprised to find out that that, too, is uncertain. Over the long run, the average has been somewhere between 4 and 6 percent per year, depending on how you measure it. That means that instead of the risk-free 5% you get in a CD or government bond you might get 10% in stocks. It may not sound like much, but over time it adds up. For a 30-year old planning to retire in 35 years, $1,000 put into a government bond at 5% will turn into $5,516 by the time they retire. If the same money were put into stocks and earned 10%, it would turn into $28,102 – more than five times as much as the less risky investment.

Still wonder why anybody in their right mind would own stocks?

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