Full article: Valuation & the Equity Market Risk Premium

Joris Kersten (1980) works with "Kersten Corporate Finance" as an independent M&A consultant in The Netherlands.

Moreover, twice a year he provides a 6-day valuation training in The Netherlands, the next one is: 28th September - 4th October 2022 at Amsterdam South (Zuidas).

M&A consulting: www.kerstencf.nl

Valuation training: www.joriskersten.nl

Article 2 of 12: Valuation & Equity Market Risk Premium (CAPM)

Author article: Joris Kersten, MSc BSc RAB

Source blog - Book: The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.

Introduction to the Equity Market Risk Premium (EMRP)

The Equity Market Risk Premium (EMRP) is the most significant number in cost of capital analysis.

The EMRP is the additional expected return that an investor demands for putting his or her money into equities of average risk, rather than a risk free instrument. The formula is:

EMRP = The expected return on a fully diversified market portfolio of securities – (minus) the expected return on a risk-free security proxied by the return on a government bond.

The EMRP can be calculated based on a:

-Historic approach;

-Forward looking approach.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Historic approach to determine EMRP

The most used method to determine the EMRP is the “historic approach”. And within this method the EMRP can be calculated with “Arithmetic means” versus “Geometric means”.

Historic returns achieved by a diversified market portfolio of equities are best proxied by the returns achieved from the stock market itself. And historic returns on government bonds (risk free rate) can then be subtracted to give an estimate for the EMRP.

And now is the question how these historic returns should be calculated. It can be done with arithmetic means or geometric means, and the resulting EMRP will differ depending on the type of mean that is adopted.

Arithmetic means suggest higher historic EMRPs than geometric means. This is because an arithmetic mean simply averages the individual annual returns over the period considered. But geometric means calculate the annual compound growth over the period.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Historic estimates of the EMRP

The historic EMRP also depends on the number of past years over which it has been calculated. This can result in a big variation in the level of the EMRP itself.

In the US, data going back to 1926 published by “Ibbotson” is widely used. Here they come up with a EMRP of 5.8% (geometric).

Within this respect it is interesting to note that when looking at the period 1926-1961 and 1962-1997 the EMRP is respectively 7,6% and 4.0% (both geometric). This means that the EMRP is going down.

Explanations could be that:

-From 1962-1997 stock markets were relatively stable and bond markets relatively unstable. This would lead to an increase in fixed income returns (bonds) which brings the EMRP down;

-From 1962-1997 a substantial increase in pension funds and other long term investors came to the market. And an increase in supply of capital leads to a reduction in the EMRP (ceteris paribus).

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Forward looking approaches: Bottom up model

Forward looking approaches estimate the EMRP on the basis of market forecasts rather than historic returns. Here for are two basic techniques: bottom up studies and top down reviews.

Bottom up models typically work by projecting future company dividends. And then the internal rate of return (IRR) is calculated that sets out the current market capitalization equal to the present value of the future expected dividends. (I will discuss this “dividend discount model” later in this sequence of blogs on the “cost of capital”)

And a similar procedure can be applied to all companies in aggregate, in order to obtain a measure of the expected growth rate of the market.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Forward looking approaches: Top down approach

The top down approach uses a combination of the dividend yield model and long-term GDP growth to estimate expected returns.

The model takes the aggregate current dividend yield of the market and adds to this long term GDP growth as an estimate for growth in corporate dividends.

The rational for using GDP growth as an estimate for the growth of dividends is that it is a reasonable assumption that the share of profits in GDP will remain constant in the future. This would imply that GDP growth could be a satisfactory estimate for the growth of corporate dividends.

E.g. If the aggregate dividend yield in the market was 3% and estimated long term GDP growth 2,5% then the future equity returns are estimated 5,5%.

With a risk free rate of 2%, this would imply a 3,5% EMRP.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Summary on EMRPs to use

Depending on whether you look at historic (arithmetic or geometric) or future approaches to determining the EMRP one gets different numbers.

Under here I summarize the possible outcomes for EMRPs to use (in developed markets):

-EMRP historic: Between 4% and 8%;

-EMRP forward looking: Between 2% and 6%.

I believe that for every valuation professional it is very important to pick an EMRP in your models and valuation reports WITH a source, and explanation on how, and why, you think this EMRP is suitable for your valuation.

(Tim Ogier, John Rugman, Lucinda Spicer, 2004)

Source blog - Book: The real cost of capital: A business field guide to better financial decisions (2004). Prentice Hall Financial Times/ Pearson Education. Tim Ogier & John Rugman & Lucinda Spicer.

Thanks for reading, hope to see you next week again, then the article will be about the "Capital Asset Pricing Model" (CAPM).

Best regards, Joris