What is a risk premium?
A risk premium is the extra return an investor demands for putting money into a risky asset rather than a risk-free one, such as a government bond. The higher the perceived risk, the higher the risk premium. It is a key building block when setting the required rate of return used to value a company.
Risk premium for unlisted companies
Unlisted companies often carry higher risk than listed ones: lower liquidity, shorter track record and less transparency. An extra risk premium is therefore often added to the required return, which lowers the valuation compared with an equivalent listed company. This is related to the concept of a liquidity discount.
Risk premium and valuation
In a discounted cash flow valuation, future cash flows are discounted by a required return that includes the risk premium. A higher required return gives a lower present value. The risk premium is therefore decisive for how a company is valued.