Equity Risk Premium (ERP) is defined as the expected return on the stock market in excess of the return on risk-free bond. ERP guides investment managers to decide how their funds should be allocated between stocks and fixed income securities and thereafter to formulate a portfolio of expected returns. ERP can be estimated by 3 methods, namely the Historical Data approach, Gordon Growth Model Approach and the Price Earnings Ratio Approach.
The Historical Data Approach utilizes differences over annual returns in stocks and bonds over a long time period to estimate forward ERPs. While the use of historical data offers an easy means of estimation, the need for long periods of historical data to minimize estimation error is a disadvantage to emerging markets. The Gordon Growth Model is forward looking in that it assumes a constant dividend growth rate in the future.
This is particularly applicable to developed companies where dividend payouts and real earnings are estimated based on GDP growth. However, the company’s actual dividend growth may not match the GDP and hence the ERP estimate may be biased upwards. The Price Earnings Ratio Approach utilizes the Earnings Yield to measure ERP based on the assumption that the returns in any form of investment by the firm are similar. This overly simplistic assumptions as well as future earnings yield will be similar to historical performance are the key weaknesses to this method.
Equity Risk Premium (ERP) is defined as the expected return on the stock market in excess of the return on risk-free bond. This excess return compensates the investor for the relatively higher risk he/she has to bear in the equity market. ERP guides investment managers to decide how their funds should be allocated between stocks and fixed incomes securities and thereafter to formulate the portfolio expected returns. The importance of asset allocation cannot be over-emphasized as it is the key to put the discipline into investment to achieve long term sustainable gains, in accordance to the clients/funds risk appetite. The significance of the ERP in asset allocation decisions for investment managers can be seen in the following 3 ways:
To arrive at the asset allocation decision, the fundamental data required is to determine the relative risks and expected returns between stocks and bonds. The ERP estimated through one of these approaches (1) Historical Data Approach, (2) Gordon Growth Model Approach, and (3) Price Earnings Ratio Approach provides this essential data for decision making. Proper asset allocation decisions are made based on the expected future risk premium as well as the reasons why it might differ from the past. Historical ERP is commonly used as a reference to compare with the current ERP. In general, an ERP of a stock below its historical ERP could mean that the stock value is likely to increase in its ERP in time. Similarly, a stock with an ERP that is higher than its historical value could also be that the stock is overbought and could return to its mean value in time.
Similarly, if the investment manager is managing a pension or retirement fund, the ERP plays an important consideration as it would mean a situation of under-funding and thereby putting the fund into deficit in the long run. Assuming the ERP is lower than the historical levels, this means that the expected returns of common stocks will be lowered too. To generate the required returns on investment, the investment manager may have to allocate more to stocks from bonds (thereby possibly incurring more risks) or increase the fund size.
2 Discuss the strengths and weaknesses of each of the following techniques used to estimate the ERP a. Historical Data Approach b. Gordon Growth Model Approach c. Price Earnings Ratio Approach The Equity Risk Premium (ERP) can be estimated via 3 methods, namely thru’ the use of Historical Data, the Gordon Growth Model or thru’ the Price-Earnings Ratio approach. The respective strengths and weaknesses of each of these approaches are discussed in the following sections:
a. Historical Data Approach. The Historical Data Approach towards estimating ERP utilizes differences over annual returns in stocks and bonds over a long time period to estimate forward ERPs. A considerable time period is required to provide some level of credibility to estimated forward ERP. In the US, historical data can go as far back as the 1800s. One of the key strengths of using historical data to estimate ERP is the ease of obtaining the estimate, i. e. by studying trends related to the mean returns in the past to project future values of ERP. There are several criticisms, though, of using this approach, chief of which is the length of the time period used to calculate ERP.
Longer time periods invariably result in lower standard errors. This problem is especially evident in emerging markets, where there is a shorter time period from which to obtain the data. Furthermore, the period chosen may not accurately reflect the outcome in the future (e. g. certain events are one-off incidents in history). Another weakness lies in the choice of using either arithmetic average or geometric average to estimate the returns on stocks, bonds and bills.
An arithmetic average would be ideal to provide an unbiased estimate of the ERP for the next year if annual returns are uncorrelated over time. However, the geometric average seems to be a better choice if returns on stocks are negatively correlated over time. One other criticism of this approach lies in the choice of treasury bills or bonds as the risk free rate. Any premium earned by stocks should be over this chosen rate and thus it is advisable that the risk free rate chosen has to match up to the duration of the cash flows being discounted. Lastly, the underlying assumption used in the historical data approach is that investors’ risk premium have not changed over time and the average risk investment in the market portfolio has remained stable over the period examined. This is highly debatable and the assumption may not hold.