31-05-2012, 04:09 PM
Equity Risk Premium Article
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Introduction
What is the equity risk premium? The equity risk premium is defined as the reward that investors
require to accept the uncertain outcomes associated with owning equity securities. The equity
risk premium is measured as the extra return that equity holders expect to achieve over risk-free
assets on average.It is important to note that the equity risk premium as it is used in discount rates and cost of
capital analysis is a forward looking concept. That is, the equity risk premium that is used in the
discount rate should be reflective of what investors think the risk premium will be going forward.
Uses of the Equity Risk Premium
The equity risk premium is a key element in many cost of equity models. The build-up approach,
capital asset pricing model, and Fama-French three factor model all require an equity risk
premium to compute a cost of equity. The higher the equity risk premium the higher the cost of
equity.
Build-Up Methodology
The build-up methodology starts with a risk-free rate and adds other elements of risk to that rate
to come up with an appropriate cost of equity. If, for example, you are trying to determine the
cost of equity for a small manufacturing facility using the build-up approach, the initial element
is the risk-free rate. Other elements include the equity risk premium and size premium. Therefore
the build-up approach would be the risk-free rate plus the equity risk premium plus the size
premium.
Capital Asset Pricing Model
The capital asset pricing model (CAPM) is an extension of the build-up approach. CAPM is
stated as follows:
Why Do We Care About The Equity Risk Premium?
Why is there so much debate about the equity risk premium? The answer is that it can have a
profound effect on the ultimate cost of equity derived. As we will outline later in this article,
depending on the assumptions that you use, the equity risk premium that you calculate can range
from below 4 percent to over 8 percent. What does this mean?
The Income Return Versus the Total Return
The use of the income return, as opposed to the total return, for the appropriate horizon Treasury
as a representation of the riskless rate is another area of discussion. Ibbotson uses the income
return in calculating the ERP rather than the total return since it represents the truly riskless
portion of the return. Yields have been rising generally over the period 1926-1996 causing
negative capital appreciation on the long-term bond series. This negative return is due to the risk
of unanticipated yield changes. Any anticipated changes in yields will already be priced by the
market into the bond. Therefore, the total return on the bond series does not represent the riskless
rate of return. It includes the effects of unanticipated interest rate changes. The income return
better represents the riskless rate of return since an investor can hold a bond to maturity and be
certain of obtaining the income return and return of principal with no capital loss.