Equity Risk Premium

“Equity risk premiums are a central component of every risk and return model in finance. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. The standard approach to estimating equity risk premiums remains the use of historical returns, with the difference in annual returns on stocks and bonds over a long time period comprising the expected risk premium, looking forward. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and noisy. We suggest ways in which equity risk premiums can be estimated for these markets, using a base equity premium and a country risk premium. Finally, we suggest an alternative approach to estimating equity risk premiums that requires no historical data and provides updated estimates for most markets.”

– – – Aswath Damodaran, Stern School of Business

Marquee Perspective – Professor Damodaran, a well-known financial guru, offers a clear and concise overview of how the Equity Risk Premium (“ERP”) is calculated and applied. ERP is a critical input in Discounted Cash Flow valuation and Professor Damodaran provides both the methodology and the concerns and issues associated with different approaches. He also highlights something that we at Marquee are fond of stressing: just because a number gets spit out of a model does not mean it can be used without question. He perceptively questions the low ERP measured at the end of the last century which reflected the stock market bubble.

Click here for a pdf of the complete article.