Professor Aswath Damodaran (New York University Stern School of Business) has updated his article, “Equity Risk Premiums (ERP): Determinants, Estimation and Implications – The 2016 Edition.”The 136-page article provides a detailed picture of ERPs. While most appraisers use the ex post approach (historical information), some experts consider the ex ante approach. Damodaran is a strong proponent of implied equity risk premiums, which are forward-looking estimates that are extracted by examining stock prices today and expected cash flows in the future. His article and his website offer very rich data on ERP and other aspects of valuation—all of it free.
In the updated article, he also seeks to dispel what he calls widely held misconceptions about equity risk premiums:
- Estimation services ‘know’ the risk premium. Historical data are available to everyone, so “there is no reason to believe that any service has an advantage over any other, when it comes to historical premiums,” he claims.
- There is no right risk premium. This is the flip side of Myth No. 1, that the data are “so noisy” that “any risk premium within a wide range is therefore defensible.” The paper points out that it is entirely possible to come up with “outlandishly high or low premiums, but only if you use estimation approaches that do not hold up to scrutiny.”
- The equity risk premium does not change much over time. “Shocks to the system,” such as the events of 2008, can cause premiums to jump quickly. “A failure to recognize this reality will lead to analyses that lag reality.” Damodaran estimates an implied ERP monthly.
- Using the same premium is more important than using the right premium. If everyone consistently used the same premium without testing it, there would be “systematic errors in valuation.”
- If you adjust the cash flows for risk, there is no need for a risk premium. This is “technically correct,” he points out, but says that “adjusting cash flows for risk has to go beyond reflecting the likelihood of negative scenarios in the expected cash flow.”
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