The Implied Equity Risk Premium - An Evaluation of Empirical Methods
Kredit und Kapital, Vol. 40, No. 4, pp. 583-613
32 Pages Posted: 14 May 2004 Last revised: 15 Aug 2008
Date Written: October 16, 2007
A new approach of estimating a forward-looking equity risk premium (ERP) is to calculate an implied risk premium using present value (PV) formulas. This paper compares implied risk premia obtained from different PV models and evaluates them by analyzing their underlying firm-specific cost-of-capital estimates. It is shown that specific versions of dividend discount models (DDM) and residual income models (RIM) lead to similar ERP estimates. However, cross-sectional regression tests of individual firm risk suggest that there are qualitative differences between both approaches. Expected firm risk obtained from the DDM is more in line with standard asset pricing models and performs better in predicting future stock returns than estimates from the RIM.
Keywords: equity risk premium, cost of capital, expected stock returns
JEL Classification: G12
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