A new(ish) model for estimating the ‘Risk Premium Factor’

BVWireIssue #114-2
March 14, 2012

“Most approaches to deriving the equity risk premium (RFP) involve calculating a fixed spread between historical equity returns and the risk-free rate,” says Stephen Hassett (Hassett Advisors). His new model “differs significantly, in that the ERP is simply a function of the risk-free rate times a constant called the Risk Premium Factor (RPF), where Equity Risk Premium = Risk Free Rate x RPF.” Further:

The RPF Model is built on a simple constant growth equation where P = E / (C - G), and explains S&P Index levels with good accuracy for 1960-present using only the long-term Treasury yields, S&P 500 operating earnings, and some simplifying assumptions. P is predicted price for the index, E is index earnings, C the cost of capital, and G, the expected long-term growth rate.

Hassett first introduced his “Risk Premium Factor” model in 2010, in the Journal of Applied Corporate Finance, in the article, “The RFP Model for Calculating the Equity Market Risk Premium and Explaining the Value of the S&P with Two Variables.” More recently, he’s posted an article that focuses on earnings as the driver of P/E, and another on interest rates. Analysts who want to look further into this subject can read Hassett’s book, The Risk Premium Factor, which Roger Grabowski (Duff & Phelps) recommends (on the back cover) for its explanation of “the economic interrelationships that drive the pricing of the broad stock market and the equity risk premium."

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