Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2018 Edition

133 Pages Posted: 19 Mar 2018 Last revised: 30 Jul 2018

Aswath Damodaran

New York University - Stern School of Business

Date Written: March 14, 2018

Abstract

The equity risk premium is the price of risk in equity markets and is a key input in estimating costs of equity and capital in both corporate finance and valuation. Given its 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 the equity risk premium, historical returns are used, with the difference in annual returns on stocks versus bonds, over a long 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.

Suggested Citation

Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2018 Edition (March 14, 2018). Available at SSRN: https://ssrn.com/abstract=3140837 or http://dx.doi.org/10.2139/ssrn.3140837

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

Register to save articles to
your library

Register

Paper statistics

Downloads
5,336
rank
1,326
Abstract Views
13,943
PlumX