The Equity Risk Premium (ERP) is the extra return an investor requires for investing in stocks

rather than risk-free assets, compensating him for taking on the relatively higher risks associated
with equities. In practice, it is the return of a stock index representing the market portfolio, minus
a risk-free asset, typically the 10-year government bond:

Equity Risk Premium = Expected return on the market – risk-free rate

The more pessimistic investors are about the market, the higher the risk premium will be.

Depending on the estimation approach, equity risk premium can be historical, implied, or based
on surveys of investors, portfolio managers, and CFOs. we will focus on the Implied ERP.

While the historical ERP is estimated based on historical data, the implied ERP estimation
approach is based on future data. It is estimated through a dividend discount model in order to
calculate an implied cost of equity based on the price level of the index. We will need to estimate
future dividends or free cash flows-to-equity using the Gordon growth model, the two-stage
model, or the three-stage model, depending on our views on the index, and then solve for the
implied cost of equity.

Simplistically, the formula for the implied cost of equity is:

Where the t is the time from now to infinity, the market value of the index is the level of the
index, the cash flow is the expected dividends and buybacks of the index, the implied cost of
equity – the only "unknown” in the formula – is calculated by solving for Ke. Then, the implied
ERP is calculated by deducting the risk-free rate from the implied cost of equity:

Implied ERP = Implied cost of equity – 10-year government bond yield

Note that the implied ERP is not multiplied by beta as the beta of a broad index portfolio equals
one by construction.
Illustration
Let us take the Moroccan All Shares Index (MASI) as a proxy for the broad stock market of
Morocco. To estimate the implied equity risk premium, we will use a three-stage model.

We look at dividends as a percentage of the index from 2009 to 2018 in order to get normalized
dividends. As we can see in the table below, the dividends averaged 3.75% of the index each
year:

Dividends on MASI Index from 2009 to 2018

Applying the 3.75% yield to the current market value of the index (11 113.87 as of
04/19/2019) results in normalized dividends of 416.3 index points:

Normalized dividends = 3.746% x 11 113.87 = 416.3

We will assume that dividends grow 5% during the first stage and gradually converge at 3% in
2028. For the terminal value, we will use a growth rate of 3%.

The expected dividends over the next years can be seen in the table below:

The estimation of expected dividends in the next ten years on MASI Index
Based on the expected dividends and the actual price level of the index, we will solve (using
Excel Solver) for the implied cost of equity in the following equation:

Then, the implied ERP is calculated netting out the risk-free rate from the implied cost of equity:

The estimation of MASI’s Implied Equity risk premium:

Note that we could have gotten a higher implied ERP if we had taken buybacks into account.

The advantage of the implied ERP is that it is forward-looking and does not rely heavily on
historical data. For this reason, it is consistent with the methodology used in DCF models. It is
implied from equity market values, reflecting the reality of the market as we included the current
level of the index and the risk-free rate. Finally, it is consistent with the efficient market
hypothesis, which implies that prices fully reflect all available information about a particular
stock or market or both. However, the implied ERP is highly dependent on the estimation of
future dividends and cash flows, numbers that are sometimes unpredictable in emerging markets.
Efficient market hypothesis (EMH) was formulated by Fama, Eugene F, (1970), who argued that
stocks always trade at their fair value.

SOURCE: ZARGUI, H (2020). BANK VALUATION DEMYSTIFIED, a

practical guide with real-world case studies available at https://lnkd.in/gPmXQUE