The Equity Premium in Finance and Valuation Textbooks

Abstract:     
This paper is a revision of the recommendations about the risk premium found in the the main finance and valuation textbooks. We revise several editions of books written by authors such as Brealey and Myers; Copeland, Koller and Murrin (McKinsey); Ross, Westerfield and Jaffe; Bodie, Kane and Marcus; Damodaran; Copeland and Weston; Van Horne; Bodie and Merton; Stowe et al; Pratt; Penman; Bruner; Weston & Brigham; and Arzac.

We highlight the confusing message of the textbooks regarding the equity premium and its evolution.

The main confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium (HEP), Expected equity premium, Required equity premium (REP) and Implied equity premium (IEP).

Some confusion also arises from not recognizing that although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors. A unique IEP requires assuming homogeneous expectations for the expected growth (g), but there are several pairs (IEP, g) that satisfy current prices.

Keywords: equity premium, equity premium puzzle, required market risk premium, historical market risk premium, expected market risk premium, risk premium, market risk premium, market premium

JEL Classifications: G12, G31, M21

Working Paper Series