Gone are the days when you could estimate an equity risk premium using a static approach with historical data. If you do, you’ll get some “very strange-looking numbers in valuation,” says Dr. Aswath Damodaran (Stern School of Business, New York University).
Alternative approach: “We live in a world where equity risk premiums are dynamic,” he said during a recent BVR webinar. “They shift and they change on you.” So instead of a using a backward-looking approach in estimating equity risk premium, he proposes an alternative: a forward-looking method he calls the “implied premium approach.”
He explains: “I am going to see what you paid for stocks and I am going to back out what your expected future risk premium is. It sounds fancy, but if you ever computed the year-to-maturity in a bond, then you will be able to see why an implied equity risk premium is pretty much the analogous computation looking at equities.”
Damodaran, who says that “equity risk premiums are one of my obsessions,” gives full details in his webinar, Equity Risk Premiums: Looking Back, Looking Forward. We’ll also analyze his approach in a future issue of Business Valuation Update.