Equity Risk Premium
[ERP]
Sources:
Dissecting India’s Equity Risk Premium
Authored by Vishnu Giri, and Sireesha Sivala – PWC
Valuation Insights – Equity Risk Premium in India – Grant Thornton
Demystifying Equity Prices using Dividend Discount Model: An Indian Context – RBI
Estimating an Equity Risk Premium for India - Shashank Gupta
Equity Risk Premium [ERP]
• ERP is the incremental return (premium) that
investors require for holding equities rather than a
risk-free asset.
• It is the difference between required return on
equities and a specified expected risk-free rate of
return.
• Using the equity risk premium, the required return
on the broad equity market or an average
systematic risk equity security is
Required return on equity = current expected risk-
free return + Equity Risk Premium
Equity Risk Premium [ERP]
• Brealey Myers in ‘Principles of Corporate Finance’
defines equity risk premium (ERP) as
‘the difference between the returns expected on the
market and the interest rate on treasury bills’.
• The ERP may be viewed as
‘risk compensation’ for investing in equity markets as
against assets that are relatively risk-free.
Equity Risk Premium [ERP]
• ERP has numerous applications:
Valuation of companies,
Capital budgeting
Economic policymaking.
Several papers have attempted to determine the ERP
for developed markets, notably the US.
The most widely used method for determining ERP is
the historical method, which is based on the
fundamental hypothesis that excess returns earned in
the past serve as a reasonable parameter for excess
returns that can be expected in the future.
Equity Risk Premium [ERP]
• While the historical method may work reasonably
well for developed markets like the US with a fairly
long history.
• The same approach is likely to yield dissatisfactory
results for emerging markets like India, with relatively
short and volatile equity market histories.
ERP parameters
• By definition, the ERP is the difference between the
expected return on the market and the risk free
rate.
• Hence, it is important to first define the following:
• The market
• The risk-free rate
The market
• Selection of an index as a proxy for the equity
market can be quite a task – essentially, the chosen
index should be reflective of the market as a whole.
• Hence logic dictates a compelling case for the the
BSE 500 rather than the BSE Sensex, which includes
only 30 stocks or NSE 500.
The market
• In this context, it is important to note that the ERP
is an integral component of the Capital Asset
Pricing Model (CAPM).
• Which states that a company’s cost of equity is
equal to the aggregate of the risk-free rate and the
ERP multiplied by the said company’s systematic
risk (beta).
The market
• Therefore, for application in the CAPM, there has to
be consistency between the beta and the ERP, i.e.
the beta should be measured against the same
index, based on which the ERP has been
determined.
• Since in India betas are generally measured against
the BSE Sensex (or the NSE Nifty, which is highly
correlated with the Sensex) it is best to measure
ERP using the Sensex or the Nifty.
The risk-free rate
• The risk-free rate can be defined as the return on a
security or portfolio of securities that has no
default risk and is completely uncorrelated with
returns on anything else in the economy.
The risk-free rate
• No security may be 100% risk-free.
• Practically there are three alternatives for determining the
risk-free rate;
• Treasury bills,
• 10-year treasury bonds,
• 30-year treasury bonds.
• The rate on 10-year treasury bonds is generally considered
the superior choice, considering better duration matching
compared to short-term treasury bills, and smaller beta
and lower liquidity premium compared to longer term (30-
year) bonds.
The risk-free rate
Country RFR
US 1.2306
UK 0.5820
Japan 0.0180
Australia 1.2010
Brazil 9.3350
Russia 6.8900
India 6.2040
Canada 1.1960
Italy 0.6312
South Africa 8.8200
Indonesia 6.3020
South Korea 1.8750
[Link]
Approaches for estimating
ERP
Methods to determine ERP
• Historical premium method
• Implied premium method
• Survey method
Estimating ERP – Historical
Estimates – selection of variables
• The Analyst’s major decisions in developing a
historical equity risk premium estimate include
selection of:
• The equity index to represent equity market returns
• The time period for computing estimate
• The type of mean calculated
• The proxy for the risk-free return
Historical ERP
Average ERP for the period 2005 – 2020 at 4.7%.
ERP peaked at 8.2% during financial crisis in 2008 followed by surge in
2020 to 6% on account of coronavirus induced stress in the market.
DDM Framework based calculations
Source: [Link]
Historical ERP
• It is based on a geometric or arithmetic average of
the annual risk premia, over a sufficiently long
period of time.
• The key question here is do we have a sufficiently
long and stable history to determine a reliable
historical risk premium.
Historical ERP
• Some of the important points to consider are as
follows:
• While the base year of the Sensex is 1979, the index
was actually formulated in 1986, and the series was
back-calculated to 1979 with a fixed set of companies.
• This may have resulted in a bias in favour of
companies which generated good returns over the
1979–1986 period.
Historical ERP
• With structural changes in the economy post
liberalization in the early 1990s, the relevance of
prior equity returns for predicting future expected
returns is questionable.
Historical ERP
• Participation in the T-bill market was highly regulated
before 2000, and therefore there is no reliable
estimate for risk-free rates prior to 1999.
• While some studies have computed the risk premium
relative to the bank deposit rate, it is essentially a
short-term rate and not consistent with our definition
of the risk-free rate as the return on 10-year securities.
Historical ERP
• This leaves us with just 20 years (2000-2020) for
which a representative historical risk premium can
be reliably calculated.
• The risk premium for each of these years is
tabulated below:
Historical ERP
Historical ERP
• Drawing any conclusions from the data from the
previous slide is practically impossible.
• An alternative suggested by Prof Damodaran for
emerging markets is to adjust the equity risk
premium for a developed market, say the US, for
relative standard deviations (ratio of the standard
deviation of the subject country market portfolio to
the standard deviation of the US market portfolio).
Historical ERP
• This method is based on the hypothesis that standard
deviation being a measure of risk, the higher the
standard deviation of the index, the riskier the index
and therefore higher the risk premium.
• Equity risk premium country X = Risk premium US*
Relative standard deviation country X
• Standard deviation of these calculations are high so
as to make their calculations meaningless.
Forward-looking Estimates
Implied ERP
Gordon Growth Model
Implied Premium Approach
• The implied premium approach is based on the
fundamental premise that the expected return on the
market portfolio is built into the current market
valuations.
• This is conceptually a superior approach, as it is forward
looking, unlike the historical approaches.
• The simplest way to compute the implied premium is by
applying the Gordon Growth Dividend Discount model.
Implied Premium Approach
V = D0 * (1 + g) / (Re - g)
Where
V = Total market capitalization of the index
D0 = Dividends for current period
g = Expected growth rate in dividends
Re= Expected return on equity
Or
Re - g = D0 *(1 +g ) / V
Or
Re = Dividend yield *(1 + g) + g
Implied Premium Approach
• Once the dividend yield and expected growth rate are
determined, the expected return on equity and
therefore, the ERP, can be estimated.
• In India, the historical dividend yields have been very
low, around 1%, and the returns on equity have been
primarily through capital appreciation.
• Thus the classic Gordon Growth model will result in a
very low estimate of expected returns, and therefore,
the ERP.
Implied premium for the Market
Index
• Inputs for the computation
• Market Index = 15446
• Dividend yield on index = 3.05%
• Expected growth rate - next 5 years = 14%
• Growth rate beyond year 5 = 6.76% (set equal to risk-free rate)
• Solving for the expected return:
• Expected return on stocks = 11.18%
• Implied equity risk premium for India = 11.18% - 6.76% = 4.42%
Forward looking ERP
• ERP is based only on expectations for economic and
financial variables from the present going forward, it is
logical to estimate the premium directly based on
current information and expectations concerning such
variables.
• Such estimates are often called forward-looking or ex
ante estimates.
Estimates are often subject to potential errors related to financial
economic models and potential behavioral biases in forecasting.
Forward looking ERP – Gordon
ERP Model
• GGM or constant growth model can be used to
generate forward looking estimates of the ERP.
• The GGM estimates the risk premium as the expected
dividend yield plus the expected growth rate minus
the current long term government bond yield.
GGM ERP = + g – rLT,0
D/P is the 1-year forecasted dividend yield on the
market index, g is the expected consensus long term
earnings growth rate and r is the current long term
government bond yield.
Forward looking ERP – Gordon
ERP Model
GGM Equity risk premium estimate =
Dividend yield on the index based on year ahead
aggregate forecasted dividends and aggregate market
value
+
Consensus long-term earnings growth rate
-
Current long-term government bond yield
Forward looking ERP – Gordon
ERP Model Solution:
Dividend yield on the index
• 1-year forecasted dividend based on year ahead aggregate
yield on market index = 2.1% forecasted dividends and
aggregate market value = 2.1%
• Consensus analyst view was
that reported earnings on the +
market index will grow at Consensus long-term earnings
approximately = 7% growth rate = 7%
• A 20 year government bond -
yield was = 3.0% Current long-term government
bond yield = 3.0%
Calculate GGM ERP. = GGM ERP = 6.1%
Forward looking ERP – Gordon
ERP Model - Issues
• Forward looking estimates generally change
through time.
• There is no guarantee that the capital appreciation
will match the predicted value.
• Model assumes constant growth. It may not hold
true. In these cases, growth may consist of a rapid
growth, transition and mature growth phase.
Implied Premium Approach
• Hence it becomes imperative to analyze
dividendable cash flows as opposed to dividends.
• In other words, free cash flow yield is a more
appropriate measure compared to dividend yield.
Case let
Implied Risk Premium
using framework of
discounting cash flows
on a coupon bond
YTM Calculation
• It uses the framework of discounting cash flows on a
coupon bond to come up with the yield of that bond.
Suppose we know the following details about a
coupon bond:
• Current market price = Rs. 1,050
• Face Value = Rs. 1,000
• Annual coupon = 10%
• Maturity = 3 years
• Given these inputs, we can calculate the yield on this
bond by equating the present value of the cash flows
to its current market price.
YTM Calculation
Face Value 1000
Current Market Price 1050
Annual Coupon 10%
Maturity [in years] 3
Year 0 1 2 3
Coupon -1050 100 100 1100
Yield (IRR function) 8.06%
From Bonds to Equities
We can take the YTM concept and apply it to stocks to
calculate an implied equity risk premium.
1. The current market price is the current level of an index
(usually an index which is representative of the general
economy – for instance, NIFTY/SENSEX in the India).
2. The return on the index can be any of the following:
The actual dividend and buy back yield of the index;
The earnings yield of the index; or
Yield calculated on the basis of free cash flow to equity of the companies
constituting the index.
This yield differs from the coupons on a bond in that
returns on equity are not guaranteed (or capped) as they
are on a coupon bond.
From Bonds to Equities
3. Accordingly, we have to estimate a growth rate in the
cash flows on the index. We can use a two-stage
discount model with a high growth period (usually not
more than 5 years) before assuming stable growth.
• The growth rate in the high growth period is usually the consensus
analyst growth estimates for the index. The reason for using
analyst estimates is because we are estimating what actual market
participants are demanding from the equity markets (which is
captured in analyst estimates).
• Once the high growth period is over, we assume a constant growth
rate in perpetuity. According to economic theory, in the long run, a
country cannot grow at more than its risk-free rate forever.
Therefore, we will set the constant growth rate equal to the risk-
free rate after the high growth period.
From Bonds to Equities
4. Once we have the above inputs, we can calculate
the return which equates the present value of cash
flows to the current level of the index (we do this
with the help of the goal seek function in excel).
5. Lastly, we need to deduct the risk free rate from
this return to come up with an implied equity risk
premium.
Case let – Index data
• We enter the inputs in an excel sheet, and using the
goal seek function calculate the equity risk premium:
• INPUTS:
• Level of Index = 52,950
• Earnings Yield = 5.25%
• Current Earnings = 52,950*5.25% = 2779.87
• Payout ratio = 70% of the earnings yield [assumption]
• Three Stage Growth Rates:
• Growth Rate 1st phase = 15% (1-3)
• Growth Rate 2 phase = 7% (4-10)
• Perpetual Growth Rate = 5.46%
• Risk Free rate = 4.46% [after adjusting default risk premium]
Risk free rate = 4.46% (the risk-free rate is computed as the current yield on 10-year Indian government
bond (5.96%) minus the default risk of the Indian government (1.50%).
Using Indian index data
Country Risk Premium
Country Risk Premium
All return models start with the estimation of the risk
free rate. For an investment to be risk free, two
conditions need to be satisfied:
• There should be no reinvestment risk; and
• There should be no default risk.
Country Risk Premium
The yield on the 10-year Indian government bond was 5.96%
[assumption]. Can this be considered as the risk free rate for
the Indian market?
While the 10-year yield does not carry reinvestment risk (at
least for 10 years), given India’s sovereign bond rating of BBB-
[[Link]
The bond cannot be considered risk free.
Country risk tries to capture the risk that the Indian
government may default on its debt.
Country Risk Premium
• Therefore, we need to reduce the bond yield by the
amount of the default risk.
• Prof. Damodaran discusses various ways of computing
default risk in his paper on risk free rates and country
risk [What is the risk-free rate? A Search for the Basic Building Block – December 2008 and Country Risk:
Determinants, Measures and Implications – The 2016 Edition by Aswath Damodaran]
• As per his calculations, the average default risk of BBB-
rated countries across the world was 2.95% for 2021.
Country Risk Premium
• However, given the improvement in the Indian
economy and recognizing that fact that ratings
agencies are slow to respond, I believe that a 1.50%
default risk more adequately represents the risk
inherent in bonds issued by the Indian government.
Country Risk Premium
• Now, as mentioned above, this 1.50% represents the risk
present in the bonds issued by the Indian government and
not Indian equities.
• One way to measure the risk in equities is to scale this
default risk by the relative volatility of the Indian equity
markets versus the debt market.
• Assume, the volatility (based on last 5 years’ of data) comes
to 15.58% and 5.46% respectively [assumption] . [Volatility is
computed as the annualized standard deviation of the returns from Nifty 500 and S&P BSE India 10
Year Sovereign Bond Index for the period].
• Accordingly, we can say that the country risk inherent in
Indian equities is 4.28% which is computed as follows:
Country Risk Premium
• Country risk in equities =
Default risk on debt *
1.50 * = 4.28%
• Now that we have the country risk premium, we can compute the
implied equity risk premium for the Indian market.
• [Link]
Using mature market data
In case if US, we use a two-stage dividend discount model
and restrict the high growth period to 5 years since it is a
mature market. The data for S&P 500 index (which
represents the US economy) as of 1 August 2016 is as
follows:
Current level of the index = 2,170.84
Dividends and buybacks yield = 5.09%
Growth rate for the next 5 years = 5.14%
Risk free rate = 1.52% (10-year T-Bond rate). The growth rate in
the stable period is restricted to the risk free rate.
Using mature market data
Using mature market data
From the calculations:
• Equity risk premium is 7.57%
• Country risk premium is 4.28%
• Total risk premium of 7.57% + 4.28% = 11.85% for
India.
• To this total premium we add the Indian risk free rate
of 4.46% to yield a cost of equity of 16.31%
Survey Estimates
Survey Estimates
• Ask people what they expect.
• Survey estimates of the ERP involve asking a sample
of people – frequently experts about their
expectations for it, or for capital market
expectations from which the premium can be
inferred.
