What Does At a Premium Mean?
"At a premium" is a phrase attached to situations where a current value or transactional value of an asset is trading above its fundamental or intrinsic value. For example, "Company X is trading at a premium to company Y." Or, "A commercial building was sold at a premium to its underlying value."
There are a variety of situations where an asset trades at a premium to its fundamental value for some period, but the phrase can also reveal the speaker's own personal assessment of the asset's intrinsic value—which may be the result of a cognitive or emotional bias.
A premium can be contrasted with an asset trading at a discount.
- The phrase "at a premium" is used in both factual and opinionated statements to describe situations when an asset or security is priced higher than its fundamental value.
- In a takeover, the target stock is often acquired at a premium to market value—this is a factual usage of the phrase.
- When financial pundits say one stock is trading "at a premium" to another stock or its own fundamental value, there is often some opinion or subjective judgment mixed into the assessment.
- Stock valuation is complex, so it is difficult to definitively say a particular stock costs more than it should. That is why the market is the final say in price discovery.
Understanding At a Premium
Broadly speaking, a premium is a price paid for above and beyond some basic or intrinsic value. The word "premium" is derived from the Latin praemium, where it meant "reward" or "prize". "At a premium" is thus meant to describe that an asset as being priced higher than it is actually worth.
In the case of a takeover, for example, the acquiring company often purchases the stock of a target company at a premium to market value. This is known as the acquisition premium and is actually recognized as goodwill on the acquirer's balance sheet post-acquisition. Any offer or proposed merger being discussed at a price point above the current market price for that asset can also be said to be at a premium.
Similarly, some assets will trade at a premium to some key indicator that is usually more closely aligned with the market price. For example, a closed-end fund may trade at a premium to its net asset value (NAV) per share, with that figure usually being expressed as a percentage. For example, a fund may have a NAV of $10 a share but trade at $11. It trades at a premium of 10%.
A risk premium involves returns on an asset that are expected to be in excess of the risk-free rate of return. An asset's risk premium is a form of compensation for investors. It represents payment to investors for tolerating the extra risk in a given investment over that of a risk-free asset. Similarly, the equity risk premium refers to an excess return that investing in the stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of equity investing. The size of the premium varies and depends on the level of risk in a particular portfolio. It also changes over time as market risk fluctuates.
The word "premium" is alternatively used in finance to describe the price paid for protection from a loss, hazard, or harm (e.g. as insurance or an options contract).
At a Premium and Stock Comparisons
"At a premium" is also used when comparing two stocks that are judged to be similar. For example, if Apple is trading at $185 a share and Microsoft is trading at $123 a share, Apple can be said to be trading at a premium to Microsoft. Even then, there is the fact that the number of shares outstanding differs, making it a flawed comparison before we even address the question of how similar Apple and Microsoft really are.
However, this type of premium comparison is more commonly applied to specific ratios, such as the price-earnings (P/E) ratio of the two stocks. Using a ratio or other key performance indicator side-steps some comparison issues, but this practice can still be misleading.
Stock A may trade a premium to stock B, but there are many situations where stock A is still the superior investment no matter the premium. Perhaps stock A has a better business model, or has a better cost structure, or is a steady performer in challenging markets, or is really not overvalued at all given its revenue growth.
While the opinions in financial media can be enlightening, it is important for investors to do their research before deciding that a stock is trading at a premium compared to another stock or its own intrinsic value. The market price right now is the market price. Figuring out the intrinsic or fair value that a stock should trade at is much less clear.