Set out how an equity risk premium can be estimated from past data or from forward-looking inputs
The idea
The equity risk premium is the expected return on equities above a risk-free benchmark, usually long-term government bonds. Historical estimates average past excess returns; the choice of arithmetic or geometric mean, the period and the benchmark all change the answer, and survivorship bias tends to push it up. Forward-looking estimates include surveys, the Gordon growth model (forward dividend yield + expected long-term growth − government bond yield) and the supply-side model, which builds the expected return from expected inflation, real EPS growth, any change in the P/E ratio and the income return, then subtracts the bond yield. The traps are compounding the P/E change with the wrong sign and subtracting a short-term rate.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
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- Benchmark a company's cost of capital and capital structure against those of its peers