Damodaran: ERP is the ‘receptacle for all macro-economic fears’

BVWireIssue #118-1
July 11, 2012

Professor Aswath Damodaran has just posted his latest monthly update to the domestic equity risk premium on his website: 6.17% as of June 29. Implicit in his calculations are two key points, Damodaran emphasizes in his latest post to Musings on Markets (also available at his site): “The first is that the equity risk premium is a macro number that applies to all stocks. The second is that the ERP is the receptacle, in intrinsic valuation, for all macro-economic fears.” In fact, Damodaran continues to use the ERP as a vehicle for discussing the latest macroeconomic crises, from the U.S. ratings downgrade last summer to the more recent “default dances” in Europe.

“Should equity risk premiums vary across countries?” Damodaran asks. At first glance, the answer might be, “Of course!” After all, Greece and Russia are riskier countries to invest in than, say, Switzerland or Canada. But “there are two scenarios [in which] country risk will cease to matter,” he says. The first is when the country risk is idiosyncratic, i.e., it has no spillover effect to other countries. The second assumes the increasing “global diversification” of investors’ portfolios permits the computation of a “global” ERP, one which captures macroeconomic risks around the world and estimates betas for individual companies against a global equity index.

“Both assumptions are difficult to sustain,” Damodaran says. Institutional restrictions plus investor biases still make global diversification difficult. Bottom line: “I think that ERPs do vary across countries, with higher ERPs applying to riskier countries. Applying the same ERPs across companies will lead you to overvalue companies that have higher exposure to emerging markets.”

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