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101 Concepts for the Level I Exam

Essential Concept 44: Equity Risk Premium

The equity risk premium is the incremental return above the risk-free rate that investors expect from holding equities. It can be used to calculate the required return for a particular stock.

Required return on a stock = current expected risk-free return + βi * equity risk premium

Historical equity risk premium is the mean value of the difference between a broad-based equity market index returns and government debt return over some selected period

  • Generally, longer time period is better, but if the selected is too long then there is a risk that ERP has permanently shifted to a different level.
  • Geometric mean is preferred over arithmetic means
  • Long-term government bond yield preferred over short-term T-bill rate

In the adjusted historical approach, adjustments are made for biases in data series. Two examples of biases are: 1) survivorship bias and 2) string of unexpectedly positive or negative events over measurement period that don’t balance out.

Forward-looking estimates, or ex-ante estimates, are estimates based only on expectations for economic and financial variables from the present going forward, so they are theoretically more appropriate. They are less likely to be subject to issues such as nonstationarity or data biases than historical estimates. However, their drawback is that they are subject to potential errors to models and behavioral biases on forecasting.

The three approaches to forward looking estimates are:

  • Gordon growth model estimates
  • Macoreconomic model estimates
  • Survey estimates: gauge expectations by asking experts for their estimates of the ERP

GGM equity risk premium estimate = market dividend-yield + consensus long-term earnings growth rate – current long-term government bond yield

Macroeconomic equity risk premium = {[(1+ expected inflation) * (1+ expected growth in real EPS) * (1 + expected growth in P/E ratio) -1.0] + expected income component)} – expected risk-free return

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