Equity Premium: Historical, Expected, Required and Implied

Abstract

The equity premium designates four different concepts: Historical Equity Premium (HEP); Expected Equity Premium (EEP); Required Equity Premium (REP); and Implied Equity Premium (IEP).

We highlight the confusing message of the textbooks and academic articles regarding the equity premium and its evolution. The confusion arises from not distinguishing among the four concepts and from not recognizing that although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors.

There is a kind of schizophrenic approach to valuation: while all authors admit different expectations of equity cash flows, most authors look for a unique discount rate. It seems as if the expectations of equity cash flows are formed in a democratic regime, while the discount rate is determined in a dictatorship.

A unique IEP requires assuming homogeneous expectations for the expected growth (g), but we show that there are several pairs (IEP, g) that satisfy current prices. We claim that different investors have different REPs and that it is impossible to determine the REP for the market as a whole, because it does not exist.

We also investigate the relationship between (IEP - g) and the risk free rate.

Keywords: equity premium, equity premium puzzle, required market risk premium, historical market risk premium, expected market risk premium, risk premium, market risk premium, market premium

JEL Classification: G12, G31, M21