Friday, February 25, 2011

Equity Risk Premiums: The 2011 Edition

As many of you who have been readers of my posts know, I have a bit of fixation on the equity risk premium and have had several posts on the topic. The equity risk premium is what investors charge over and above 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 premium is a central number in both corporate finance and valuation. In corporate finance, it determines the costs of equity and capital for firms, and by extension, their investment policies. It also drives the choice between debt and equity and determines whether the company should be accumulating cash or returning it to stockholders. In valuation, it is a key input to the value of any company.

The message that I have tried to deliver is that this number is too important to be be viewed as a constant or outsourced to someone else. Thus, the defense that is offered by many investment banks, consulting firms and corporations that the equity risk premium that they use comes from a reputable 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 ownership of this number.

A confession, though, is a good place to start this discussion. I used to think that equity risk premiums in developed markets were fairly stable numbers and that mean reversion (assuming that things move back to a normal or at least average level) was a safe assumption. That is.. until September 2008. I got a wake-up call between September 2008 and December 2008 about the dangers in this assumption as equity risk premiums in developed markets exploded.. by my estimate, the equity risk premium in the S&P 500 almost doubled in two months. I wrote a paper on equity risk premiums in the midst of that crisis in November 2008 and the response indicated that quite a few other people were just as concerned as I was about the lack of attention that practitioners paid to what the equity risk premium was and what it was measuring.

Gratified by the response to that first attempt, I have returned to the well two times and done updates of the equity risk premium paper at the start of 2009 and 2010. Since we are into 2011, I just finished my latest update on equity risk premiums and you can get it here:

It is awfully an long paper (about 94 pages) and I apologize in advance. Some of the verbosity can be attributed to verbal diarrhea, an occupational hazard for someone who loves writing and likes hearing himself talk. Some of the length, though, is due to the fact that this is a widely researched topic, examined from many different angles, and I felt the urge to present a full picture.

Here, though, are my summary thoughts/ findings:
1. The equity risk premium is neither a mathematical number nor is it a statistical number. Instead, it is a reflection of what investors are feeling in their gut: if investors feel more worried about the future, the equity risk premium will rise. After the last week (Feb 20-24, 2011) in the Middle East (Egypt in turmoil, Libya on the edge, the House of Saud wondering whether the bells will be tolling for them), equity risk premiums have probably risen across the globe.

2. Pragmatically, though, there are only three ways of estimating the equity risk premiums:
a. You can survey investors, portfolio managers, CFOs or even academics to get a sense of what they think is a reasonable value for the equity risk premium. As I note in the paper, these survey premiums right now indicate that people seem pretty sanguine about equity risk and the risk premiums have dropped from what they were two years ago. The actual values range from just above 3% (from CFOs) to just under 4% (portfolio managers).

b. You can look at the past and look at the actual premiums earned by stocks over riskless investments in the past. I do this as well, using the long historical database that we have in the US, and estimate that stocks have earned an average premium of 4.31% over treasury bonds between 1928 and 2010. That is very close to the 4.29% that I reported as the historical premium last year, using 1928-2009 data. However, there are two caveats. Even with this long time period, the standard error in the estimate is 2.38%; applying the standard plus or minus two standard errors to the 4.31%, we would conclude that the true risk premium can be zero or greater than 9%. Second, the historical premium number itself can change depending upon your choice of riskfree rate (T.Bills or T.Bonds), time period (1928-2010, 1960-2010, 2001-2010) and averaging approach (arithmetic average or geometric average). Needless to say, I don't trust historical risk premiums.

c. You can try to estimate a forward-looking premium, by looking at what people are paying for stocks today and estimating expected cash flows in the future. On January 1, 2011, using the S&P 500 level of approximately 1258 and expected cash flows for the future, you can back out a required return on 8.49% for stocks in the index. Netting out the treasury bond rate of 3.29% on January 1, 2011, yields an "implied" equity risk premium of 5.20% for that day. While estimating future growth rates can be hazardous, I trust implied premiums more than historical premiums. Talking about updating the numbers, I estimated the equity risk premium today (Feb 24, 2011) using the level of the index at close of trading today (1306.10) and the treasury bond rate at the close of trading (3.45%) to be 4.98%.  That is up from 4.82% a week ago... I guess Libya is having an impact. By the time you read this post, that number may be dated. So, give it your best shot:
Those of you who follow me on Twitter (#AswathDamodaran) get my monthly updates on the equity risk premium, at least for the US.

d. Estimating equity risk premiums in emerging markets is more difficult to do, partly because the historical data is thinner and less reliable. Implied premiums are more difficult to estimate because of the absence of information on cash flows and growth rates. Notwithstanding these limitations, I have laid out three ways in which equity risk premiums can be estimated in emerging markets and my biases about these approaches. Looking at the big picture, though, it is astonishing how much equity risk premiums in "big" emerging markets (India, China, Brazil) have declined over the last decade, a huge contributor to the surge in equity prices in those markets.

e. Risk premiums for the most part move together across different markets, geographically and across asset classes. As the equity risk premium has changed in the US, so have the default spreads on bonds and risk premiums in real estate. When risk premiums do not move together, all too often it is an indication of a bubble in one market or a mispricing in the other.

3. The big question, of course, is which of these equity risk premium estimates is the right one to use in corporate finance and valuation. My answer is nuanced, which may surprise some of you, because I don't take kindly to nuance:
a. If your job is to be market neutral, i.e., assess the value of a company, given where the market is today, you should use today's implied equity risk premium. On February 24, 2011, this would have meant using 4.98% in a mature equity maret. Using any other premium would introduce your market views into the valuation.
b. If you are a long term value investor and don't have to answer to market metrics in the short term, you are lucky. You can then take market views into your valuation by using what you think is a better long term estimate of the equity risk premium.
c. If you are a CFO and are concerned about long term value, you can take the same point of view as the long term value investor and estimate a "normalized" equity risk premium.
d. If you are a macro strategist, you can look at implied equity risk premiums in different market to make your judgment on where you want to invest your money. As a general rule, you want more of your money invested in markets with high "risk premiums" and less invested in markets with 'low" risk premiums.

Bottom line: The equity risk premium is too important a number to be outsourced. Investors, managers and central banks need to keep their eyes on risk premiums in different markets.


Unknown said...

Professor Damodaran, thanks for the thought-provoking post.

I am trying to figure out why equity risk premiums have always felt weird to me.

As I view it now, investors wouldn't bother with valuation if they didn't believe they could do a better job at forecasting a company's cash flows... or even its reversion to a mean earnings multiple.

Why give up with risk? If I go through the trouble of predicting my own future cash flows, why would I use the market's estimation of risk for my projections?

Is there exploitable mean reversion in the premia?

This is a humbler question than may appear. Any insight is appreciated, and thanks again.

Unknown said...

And to clarify, I know that (at least under CAPM) a market risk premium is obviously a component, rather than the entirety, of a discount rate. But it's still an anchor, and it would seem that investors would want to be more proactive about estimating this sort of thing than many appear to be.

Aswath Damodaran said...

I am not precluding you from doing your own research on the stocks you want to invest int.. However, you are a price taker on some dimensions and the equity risk premium is the overall price of risk for investing in equities. You can always argue that this price is too high or low but that would be the equivalent of market timing.

So, you have to decide... Do you want to buy cheap stocks or do you want to time the market?

Salvador Garcia-Ruiz said...

Professor, interesting post. FYI, there is a problem with the link

Rich said...

Great post. This one will be required reading for my students! Thanks

Hariba said...

Professor I was just wondering what will happen if the index itself is overvalued at the moment

Ruy A Chaves said...

Excellent post! Question: shouldn't forward equity risk in fact be adjusted for a possible "gut expectation" of risk free rate variation?
In other words, even if current free rate is x%, market gut may be realizing that it is not sustainable and implying such expectation in the required total equity return, what would change the ERP itself.

V. said...

Good evening,

I am currently doing an assignment for my MSc Accounting and Financial Management and I need an estimation about FTSE 100 yield for 2012. I am kindly asking you if you could provide any kind of information because I cannot trust the expectations that I randomly find on the internet. Any hint would be fully appreciated..
Thank you for your time. I admire your work.

With kind regards

Anonymous said...

On business you have to take the risk but well also you sometimes have to stop to see what is happen with your company 'cause if the things are like you will lose it's better to stay away and invest in other things.

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