The Equity Risk Premium is the premium investors charge for investing in the average risk equity over and above a risk-free investment. The ERP is a dynamic number that varies over time due to changes in growth, inflation, and risk.
The equity risk premium can be used as a barometer to determine if stocks are expensive, cheap, or fairly priced by comparing the current equity risk premium to historical values.
As you’ll see below, there are multiple ways to calculate an equity risk premium. The most significant risk when determining an equity risk premium is using a growth rate that is either too optimistic or pessimistic. This is one of the reasons why we derive the equity risk premium from the S&P 500 as it’s the most widely followed index in the world, and it has the most analysts forecasting its expected growth. If you believe these experts are incorrect, you can adjust the growth rate in your calculations.
There are two ways to calculate the ERP:
- Using historical data (historical equity risk premium)
- Using future implied estimates (implied equity risk premium)
Historical risk premiums can vary dramatically depending upon the duration of history selected, the risk-free instrument chosen, and if you’re calculating the arithmetic or geometric average. They’re statistically noisy even if you go back to the 1920s. They also assume the future will look like the past, which may not be the case due to globalization. For all of these reasons, I believe using a historical ERP is a mistake.
Calculating an implied equity risk premium is a better way. Instead of looking at the past, we look at what the public is paying today. Much in the same way we calculate the yield to maturity for a bond, we can use the same technique to calculate the implied ERP.
If you would like to understand the mechanics or calculate it on your own, here’s what you’ll need:
- Determine the trailing twelve months (TTM) cash to investors by adding dividends and buybacks.
- Grow the S&P500 cash flows at the forecasted rate for five years. Again, use the S&P because it is the most followed and analyzed index in the world.
- Assume the rate of growth will drop to the growth of the economy in year 6+ by using the 10-year risk-free rate.
- Dr. Edward Yardeni provides both the dividends and buybacks and S&P growth rate.
- The U.S. treasuring provides the risk-free rate.
Download my implied equity risk premium example.
There are multiple methods to scale up an implied equity risk premium for the additional risk in emerging markets. The best way for most companies is to scale up the [default spread/cost-of-debt) of the emerging market government bond by doing the following:
- Calculate the mature market ERP.
- Take the default spread of the emerging market government bond.
- Get the standard deviation of the bond market.
- Get the standard deviation of the equity market.
- Adjust the default spread based upon the increased volatility of the equity market relative to the bond market.
There’s also a more sophisticated country risk approach. If a company generates a substantial amount of its business from another country with a vastly different risk profile, a Lambda approach may be worth the extra effort. For instance, an emerging market company generating business from the United States is less risky than a similar company generating its revenues where it’s domiciled. With this in mind, the cash flows from both companies should be discounted differently.
If you want to learn more about the equity risk premium, Professor Damodaran is the authority on the subject.