Electronic copy available at: http://ssrn.com/abstract=1492717
1
Equity Risk Premiums (ERP): Determinants, Estimation andImplications - A post-crisis Update
October 2009 Aswath DamodaranStern School of Business
adamodar@stern.nyu.edu
Electronic copy available at: http://ssrn.com/abstract=1492717
2
Equity Risk Premiums (ERP): Determinants, Estimation andImplications
Equity risk premiums are a central component of every risk and return model in financeand are a key input into estimating costs of equity and capital in both corporate financeand valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. We begin this paper by looking at theeconomic determinants of equity risk premiums, including investor risk aversion,information uncertainty and perceptions of macroeconomic risk. In the standard approachto estimating equity risk premiums, historical returns are used, with the difference inannual returns on stocks versus bonds over a long time period comprising the expectedrisk premium. We note the limitations of this approach, even in markets like the UnitedStates, which have long periods of historical data available, and its complete failure inemerging markets, where the historical data tends to be limited and volatile. We look attwo other approaches to estimating equity risk premiums – the survey approach, whereinvestors and managers ar asked to assess the risk premium and the implied approach,where a forward-looking estimate of the premium is estimated using either current equityprices or risk premiums in non-equity markets. We also look at the relationship betweenthe equity risk premium and risk premiums in the bond market (default spreads) and inreal estate (cap rates) and how that relationship can be mined to generated expectedequity risk premiums. We close the paper by examining why different approaches yielddifferent values for the equity risk premium, and how to choose the “right” number to usein analysis. (In an addendum, we also look at equity risk premiums during the marketcrisis, starting on September 12, 2008 through December 31, 2008, and then track theshift the changes through September 30, 2009.)
3The notion that risk matters, and that riskier investments should have higherexpected returns than safer investments, to be considered good investments, is bothcentral to modern finance and intuitive. Thus, the expected return on any investment canbe written as the sum of the riskfree rate and a risk premium to compensate for the risk.The disagreement, in both theoretical and practical terms, remains on how to measure therisk in an investment, and how to convert the risk measure into an expected return thatcompensates for risk. A central number in this debate is the premium that investorsdemand for investing in the ‘average risk’ equity investment, i.e., the equity riskpremium.In this paper, we begin by examining competing risk and return models in financeand the role played by equity risk premiums in each of them. We argue that equity riskpremiums are central components in every one of these models and consider what thedeterminants of these premiums might be. We follow up by looking at three approachesfor estimating the equity risk premium in practice. The first is to survey investors ormanagers with the intent of finding out what they require as a premium for investing inequity as a class, relative to the riskfree rate. The second is to look at the premiumsearned historically by investing in stocks, as opposed to riskfree investments. The third isto back out an equity risk premium from market prices today. We consider the pluses andminuses of each approach and how to choose between the very different numbers thatmay emerge from these approaches.
Equity Risk Premiums: Importance and Determinants
Since the equity risk premium is a key component of every valuation, we shouldbegin by looking at not only why it matters in the first place but also the factors thatinfluence its level at any point in time and why that level changes over time. In thissection, we look at the role played by equity risk premiums in corporate financialanalysis, valuation and portfolio management, and then consider the determinants of equity risk premiums.
Why does the equity risk premium matter?
The equity risk premium reflects fundamental judgments we make about howmuch risk we see in an economy/market and what price we attach to that risk. In theprocess, it affects the expected return on every risky investment and the value that weestimate for that investment. Consequently, it makes a difference in both how we allocatewealth across different asset classes and which specific assets or securities we invest inwithin each asset class.
Search History:
Result 00 of 00
00 results for result for
p.
Equity Risk Premium From Prof Damaodaran Oct 2009
Wonderful person, teacher Prof Damodaran from Stern School of Business
9.2K
Reads
60
Readcasts
1
Embed Views
Recommended
More From This User
Notes
Load more
