114 Pages Posted: 16 Mar 2014
Date Written: March 14, 2014
Equity risk premiums are a central component of every risk and return model in finance and are a key input in 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. In the next section, we 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.
(This is the seventh update of this piece. The first update was in the midst of the financial crisis in 2008 and there have been annual updates each year from 2009 through 2013.)
Suggested Citation: Suggested Citation
Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2014 Edition (March 14, 2014). Available at SSRN: https://ssrn.com/abstract=2409198 or http://dx.doi.org/10.2139/ssrn.2409198
By Ivo Welch