Historical ERP: Busting open one of the BV ‘myths’

In response to last week’s item on the equity risk premium (ERP)—in particular, the recent articles in the EconomistEric Nath (Eric Nath & Associates) alerted us to his article: “The Biggest Valuation Myth,” just-published in the Business Valuation Review (Fall 2011). From the summary abstract:

The traditional Capital Asset Pricing Model and Build-Up Method have failed to reliably quantify the required rates of return for equity holders. This paper discusses how profoundly business appraisers, the courts, investors, auditors and the general public have been misled into thinking that these methods are valid, and suggests a way forward using an on-line survey method (the Pepperdine University Survey).
“One of the biggest business valuation mistakes is confusing historical equity returns with expected or required equity returns,” Nath writes. “More to the point, however, is that while it might be reasonable to assert that past market behavior could influence investors’ expectations, this tells us nothing about how much influence it has, nor does it lead anywhere close to the conclusion that the past is a determinant of investor expectations.” Instead, he suggests several “better ways” of getting to an estimated return on equity; to read the complete article, visit Nath’s web site. (Where, by the way, he’s also posted his myth-busting paper on control premiums.)

Damodaran updates his ERP. “One of my obsessions is the equity risk premium,” Aswath Damodaran (NYU Stern School of Business) admits in this week’s blog. “To me, it is the ‘number’ that drives everything we do.” Two events prompted his new post: the Economistarticles as well as the 5th annual update of his paper on ERP. Importantly—and implicitly agreeing with Nath—the Professor states, with emphasis:

If I had to use a historical risk premium, I would go with the 4.10%, since it is long term, a compounded average, and over a long-term risk-free rate. However, I am much more uncomfortable with the assumption of mean reversion in the U.S. market than I used to be since, in my view, the structural shifts that have come out of globalization have changed the rules of the game. As a consequence, I no longer use historical premiums in either valuation or corporate finance.… Given the dynamic and shifting price of risk that characterizes markets today, I think it makes sense to compute and use an updated implied equity risk premium in valuation and corporate finance.
Read the complete blog post here; the Professor’s updated paper on ERP is availablehere.