Damodaran on the Equity Risk Premium

The Equity Risk Premium is one of the central concepts of finance theory and practice. However, when we teach it in class (usually as part of the CAPM), we tend to do a lot of hand-waving and tell students to use historical ERPs. Aswath Damodaran of New York University has an excellent piece on SSRN titled "Equity Risk Premiums: Determinants, Estimation, and Implications" that's a must-read whether you're a professor, student, or practitioner. Here's the abstract:

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. 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 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. (In an addendum, we also look at equity risk premiums during the market crisis, starting on September 12, 2008 through October 16, 2008.)

Read the whole thing here.

What to Use as the Equity Risk Premium?

I'm teaching Corporate Finance again this semester. In the class, we spend a fair bit of time on the CAPM (yes, I know - it's not perfect. But it is a still pretty good). One of the big issues is what to use as the Market Risk Premium (or, as it's sometimes called, the "Equity Risk Premium). Looks like I'll be using this piece as background: The Equity Risk Premium in 100 Textbooks by Pablo Fernandez of the University of Navarra. Here's the abstract:

I review 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and find that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages.

Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premium and Implied equity premium.

Finance professors should clarify the different concepts of equity premium and convey a clearer message about their sensible magnitudes.

It's worthwhile reading - you can download the full version on SSRN here.

HT: Jim Mahar at FinanceProfessor.com