New paper reviews ERP approaches

BVWireIssue #184-2
January 17, 2018

The Equity Risk Premium: A Contextual Literature Review” is by Laurence B. Siegel of the CFA Institute Research Foundation. It is a review of the research into the equity risk premium (ERP), “often considered the most important number in finance.” He points out that approaches to estimating the ERP fall into three broad categories: (1) researchers have measured the margin by which equity total returns have exceeded fixed-income or cash returns over long historical periods and have projected this measure of the ERP into the future; (2) the dividend discount model—or a variant of it, such as an earnings discount model—is used to estimate the future return on an equity index, and the fixed-income or cash yield is then subtracted to arrive at an equity risk premium expectation or forecast; and (3) academics have used macroeconomic techniques to estimate what premium investors might rationally require for taking the risk of equities. “Current thinking emphasizes the second, or dividend discount, approach and projects an equity risk premium centered on 3.5% to 4%,” says Siegel.
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