107 Pages Posted: 22 Mar 2012 Last revised: 20 Apr 2012
Date Written: March 14, 2012
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 are 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.
Keywords: Equity Risk Premiums, ERP, country risk, cost of equity, cost of capital
JEL Classification: G12, G30, G31
Suggested Citation: Suggested Citation
Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2012 Edition (March 14, 2012). Available at SSRN: https://ssrn.com/abstract=2027211 or http://dx.doi.org/10.2139/ssrn.2027211
By Ivo Welch