The equity risk premium (“ERP”) is the extra return over the expected yield on risk-free securities that investors expect to receive from an investment in a diversified portfolio of common stocks.1 It can also be thought to measure what investors demand over and above the risk-free rate for investing in equities as a class or the market price for taking on average equity risk.2
US risk-free rates are hovering at historic lows because of the perceived low risk of US treasuries relative to the sovereign debt of other developed nations, and the Federal Reserve is undertaking quantitative easing and other efforts to lower interest rates in response to economic conditions. Consequently, the capital asset pricing model (“CAPM”), which utilizes the ERP to calculate a cost of equity, is currently implying a below-average cost of equity when the market is actually considerably risky.
Research has shown that the ERP is cyclical during business cycles and that the ERP can fluctuate within its historical range based on current and forecast economic conditions. The ERP tends to move in the opposite direction of the economy, so when the business cycle is at its peak, the ERP will be at the lower end of its historical range; conversely, during economic troughs, the ERP will be at the higher end of the range.1 The historical risk-free rate and ERP are presented in the chart below.
There is no single universally accepted methodology for estimating the ERP; thus, there is wide diversity in practice among academics and financial advisors with regard to recommended ERP estimates.
American Appraisal researched and analyzed various economic and market factors in order to determine where the current ERP should fall within a range of historical ERP. To determine which indicators were most relevant to the ERP, correlations were calculated for these indicators relative to the historical ERP. Long-term correlations greater than +/- 0.5 were considered meaningful. Based on our research and analysis, American Appraisal utilizes a 6.5% ERP combined with the actual risk-free rate for second quarter 2012. Additional details of the factors we reviewed follow.
The factors determined to display moderate or strong correlations with historical ERPs were the Chicago Board Options Exchange (“CBOE”) Volatility Index (“VIX”), Damodaran’s implied premium, and Moody’s Aaa and Baa 20-year corporate credit spreads.
The VIX is the ticker symbol for the Chicago Board Options Exchange (“CBOE”) Volatility Index, which numerically expresses the market’s expectations of 30–day volatility; it is constructed by using the implied volatilities of a wide range of S&P 500 Index options. The results are meant to be forward-looking and are calculated by using both call and put options. The VIX is a widely used measure of market risk and often is referred to as the investor fear gauge. There are three variations of the volatility indexes: (1) the VIX, which tracks the S&P 500; (2) the VXN, which tracks the Nasdaq 100; and (3) the VXD, which tracks the Dow Jones Industrial Average.
Damodaran’s implied premium, developed by Aswath Damodaran, Professor of Finance at the Stern School of Business at New York University, is a forward-looking approach to calculating an expected ERP. It is based on using current market data to calculate an implied or residualized ERP.3
Moody’s Aaa corporate credit spreads are calculated based on the difference in Aaa corporate yields vs. US treasuries with similar maturities.
As described previously, the VIX, Damodaran’s implied premium, and Moody’s Aaa and Baa 20-year corporate credit spreads display meaningful correlations with historical ERPs. Each of these factors is briefly discussed below:
Damodaran’s Implied Premium
The six-month moving average trendline suggests that the implied premium is remaining relatively flat, between 6.50% and 7.00%.
CBOE Volatility Index (VIX)
The VIX appears to be trending toward its historical average (near 20) but has fluctuated considerably over the past few years, spiking to over 40 last summer. While the six-month trendline has come down, the actual index has increased during the first third of 2012.
Moody’s Aaa and Baa Corporate Credit Spreads (20-year)
Credit spreads have continued their slow trend, showing an increase since January 2010. The question is whether or not this is a signal of increased risk or whether global risk in Europe is causing flight to quality and creating anomalies in the US treasury markets.
Additional Economic Indicators
In addition to the economic and market factors that display meaningful correlations with historical ERPs, the following economic indicators are monitored on a frequent basis to determine the current status of the US economy and help establish where the current ERP falls within the historical range.
Consumer sentiment trends, as tracked by the University of Michigan, indicate improving consumer sentiment, which is typically preceded by positive economic trends. However, the most recent consumer sentiment survey indicated a drop in June 2012 relative to May 2012.
US Real GDP
The six-month moving average trendline for US real GDP indicates a relatively flat economy with slower growth trending toward 2%. This is considered a coincident indicator by economists and is neither leading nor lagging.
As the ERP is cyclical and can fluctuate within its historical range based on current and economic conditions, please consult with your American Appraisal valuation advisor when developing a weighted average cost of capital or, more specifically, the cost of equity. Visit www.american-appraisal.com for more information.
1 Shannon Pratt and Roger Grabowski, Cost of Capital: Applications and Examples, fourth edition (New York: John Wiley & Sons, 2010), pages 115, 137.
2 Aswath Damodaran, “Risk Premiums: Looking backwards and forwards…” (presentation, October 2011).
3 Aswath Damodaran, Equity Risk Premiums (ERP): Determinants, Estimation and Implications - The 2012 Edition (paper, updated March 2012).
This newsletter is provided for general informational purposes only and is based upon the information available as of the time it was written.