As a lot of you who’ve been visitors of my content know, I have a little of fixation on the equity risk premium and also have had several posts on this issue. The equity risk premium is exactly what investors charge in addition to what they can make on a riskfree investment to invest in equities, as a class.
The reason for the fixation is simple. The equity risk superior is a central amount in both corporate and business financing and valuation. In corporate finance, it determines the expenses of equity and capital for firms, and by extension, their investment policies. In addition, it drives the choice between personal debt and collateral and determines whether the company should be accumulating cash or coming back it to stockholders. In valuation, it is a key insight to the value of any company.
The message that I’ve tried to deliver is that quantity is too important to be be looked at as a continuous or outsourced to someone else. Thus, the protection that is offered by many investment banks, consulting firms and corporations that the equity risk superior that they use originates from an established source (Ibbotson, Duff and Phelps or Credit Suisse) fails the credibility test. If you run a business or have to value it, you have to take possession of the true quantity. A confession, though, is an excellent place to start this discussion.
I used to think that equity risk premiums in developed markets were fairly steady numbers and that mean reversion (let’s assume that things move back again to a standard or at least average level) was a safe assumption. That is.. until September 2008. I acquired a wake-up call between September 2008 and December 2008 about the dangers in this assumption as equity risk premiums in developed markets exploded..
S&P 500 almost doubled in two months. It is awfully an long paper (about 94 webpages) and I am sorry in advance. Some of the verbosity can be attributed to verbal diarrhea, an occupational risk for someone who enjoys writing and enjoys hearing himself speak. A number of the length, though, is because of the reality that this is a broadly investigated subject, examined from many different perspectives, and I sensed the desire to provide a complete picture. 1. The equity risk superior is neither a mathematical quantity neither is it a statistical quantity. Instead, it is a reflection of what investors are feeling in their gut: if investors feel more concerned about the future, the collateral risk superior shall rise.
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After the the other day (Feb 20-24, 2011) in the Middle East (Egypt in turmoil, Libya on the advantage, the House of Saud questioning whether the bells will be tolling on their behalf), equity risk monthly premiums have probably increased across the globe. You can survey investors, portfolio managers, CFOs or even academics to get a sense of what they think is an acceptable value for the equity risk premium. As I note in the paper, these survey premiums right now reveal that people appear pretty sanguine about collateral risk and the chance premiums have slipped from what they were two years ago. The actual values range from just above 3% (from CFOs) to just under 4% (stock portfolio managers).
You can look at the past and appearance at the actual premiums gained by stocks and shares over riskless opportunities in the past. You can test to estimate a forward-looking premium, today and estimating expected cash flows in the future by looking at what folks are spending money on shares. On January 1, 2011, using the S&P 500 degree of 1258 and expected cash flows for future years approximately, you can back out a required return on 8.49% for stocks in the index.