Current ERP at 5.5%, says new Duff & Phelps estimation

BVWireIssue #112-4
January 25, 2012

Duff & Phelps regularly reviews fluctuations in global economic and financial conditions that warrant periodic reassessments of the equity risk premium (ERP) used for developing discount rates. Based on current market conditions, Duff & Phelps has just decreased its recommended U.S. ERP to 5.5% for use as of Jan. 15, 2012, and thereafter, until further guidance is issued. The previous Duff & Phelps U.S. ERP recommendation was 6.0%, established as of Sept. 30, 2011.

“In developing our ERP recommendation, we incorporated a ‘normalized’ 20-year yield on U.S. government bonds of 4.0% as of mid-January 2012,” says Jim Harrington (Duff & Phelps). (This implies a 9.5% [5.5% + 4.0%] “base” cost of equity capital estimate for the U.S.) “Had we used the spot yield-to-maturity of 2.6% as of mid-January 2012, we would have arrived at an overall discount rate inappropriately low vis-à-vis the risks currently facing investors,” Harrington adds. The new ERP recommendation also takes into consideration recent positive economic trends, as evidenced by several indicators:

  • the unemployment rate is down, and there has been a declining trend in initial jobless claims;
  • non-farm payrolls have been ticking up;
  • corporatecredit spreads have diminished; and
  • consumer sentiment is rising by some measures.

Further, the new ERP reflects the increasing stabilization of perceived risks to U.S. markets. Despite the recent downgrade of several Euro-zone countries’ credit ratings, the Euro-zone “seems to have pulled back from what some analysts perceived to be its imminent meltdown in the fall of 2011,” says Carla Nunes (Duff & Phelps). Since then, “U.S. broad equity indices have risen significantly (e.g., the S&P 500), and equity volatility has diminished somewhat (e.g., as measured by the S&P 500 VIX index).” Reminder: for valuations dated as of December 31, 2011, the D&P 6.0% ERP estimate is still appropriate, in conjunction with a normalized 4.0% risk-free rate. For all the analysis, data, and information that went into the new D&P recommended ERP, look for Harrington and Nunes’ complete article in the March 2012 Business Valuation Update.

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