Equity Risk Premium (ERP) is one of the most sensitive inputs in any valuation. Small changes compound through the model and can move intrinsic value materially.
For Saudi valuations, the goal is a transparent ERP that has a global anchor and reflects domestic country exposure only when the business economics justify it - not as a blanket add-on.
Step 1: Start with a Global Base ERP
Use a mature market ERP as your starting point. This is appropriate when cash flows are diversified globally or the company’s risk profile is comparable to global peers.
Good sources include regularly updated implied ERP estimates from academic databases, as well as historical long-run equity risk premia from well-established markets.
Step 2: Add a Country Risk Component When Domestic Exposure Is High
If the business generates most of its cash flows in Saudi Arabia, you may add a country risk premium (CRP) derived from a sovereign spread:
CRP = CDS(KSA) × (σ_equity / σ_bond)
ERP(Saudi) = ERP(global) + CRP
The equity-to-bond volatility ratio (σ_equity / σ_bond) scales the sovereign spread to reflect that equity is more volatile than bonds. A ratio in the range of 1.2–1.5 is commonly used in practice; document your choice.
Step 3: Weight ERP by Revenue and Cash Flow Exposure
For companies with mixed domestic and international exposure, a revenue-weighted ERP is often more accurate than applying a single country premium:
ERP(effective) = [w(Saudi) × ERP(Saudi)] + [(1 − w(Saudi)) × ERP(global)]
This approach is particularly useful for Saudi companies with meaningful GCC or international revenue.
Step 4: Treat Concentration Risk as a Sensitivity, Not a Certainty
If a business is highly concentrated in a small number of counterparties, customers, or projects, you can model a small additional premium as a sensitivity - for example, 0.5% to 1.5%. Keep it explicitly illustrative, sensitivity-tested, and documented. Do not present it as a precise fact.
Illustrative Example
| Input | Value |
|---|---|
| ERP (global base) | 5.5% |
| CDS (KSA, 10-year) | 1.0% |
| σ_equity / σ_bond | 1.5 |
| CRP | 1.5% |
| ERP (Saudi) | 7.0% |
| Saudi revenue weight | 80% |
| ERP (effective) | (0.8 × 7.0%) + (0.2 × 5.5%) = 6.7% |
Always present ERP as a range and show valuation sensitivity across that range.
Common Mistakes
- Double counting - adding country risk in both the risk-free rate build-up and the ERP separately without documentation
- Applying Saudi CRP to globally diversified companies - the premium belongs where the risk is earned
- Using a single ERP input without sensitivity - given the inherent uncertainty in ERP estimation, a sensitivity range is essential
This article is for educational purposes only. It explains valuation concepts and modeling choices. It is not investment advice, a recommendation, or a financial promotion. Examples use illustrative inputs. Verify all data using primary sources and consult an appropriately licensed professional before making financial decisions.
CFA® and Chartered Financial Analyst® are registered trademarks owned by CFA Institute. This content is not endorsed by or affiliated with CFA Institute.
Abdul Gaffar Mohammed, CFA
Treasury & Investment Professional