Equity Risk Premiums (ERP): Determinants, Estimation and Implications - A Post-Crisis Update

86 Pages Posted: 24 Oct 2009 Last revised: 20 Feb 2010

Aswath Damodaran

New York University - Stern School of Business

Date Written: October 22, 2009

Abstract

Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and 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 the economic determinants of equity risk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. 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 volatile. We look at two other approaches to estimating equity risk premiums - the survey approach, where investors 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 equity prices or risk premiums in non-equity markets. We also look at the relationship between the equity risk premium and risk premiums in the bond market (default spreads) and in real estate (cap rates) and how that relationship can be mined to generated expected equity risk premiums. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the “right” number to use in analysis. (In an addendum, we also look at equity risk premiums during the market crisis, starting on September 12, 2008 through December 31, 2008, and then track the shift the changes through September 30, 2009.)

Keywords: Equity Risk Premiums, default spreads, Crisis, valuation, cost of equity

JEL Classification: G12, G32

Suggested Citation

Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications - A Post-Crisis Update (October 22, 2009). Available at SSRN: https://ssrn.com/abstract=1492717 or http://dx.doi.org/10.2139/ssrn.1492717

Aswath Damodaran (Contact Author)

New York University - Stern School of Business ( email )

Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0340 (Phone)
212-995-4233 (Fax)

HOME PAGE: http://www.damodaran.com

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