Thus, to estimate the equity risk There is a firm-specific component that returns. Finbox Inc ( https://finbox.com/ ) is a Chicago-based online toolbox for investment and financial professionals that covers over 95,000 companies worldwide through their partnership with Standard & Poor’s Market Intelligence. not diversifiable and can command a premium. to the treasury bond rate of 5.14% on that day results in an implied equity To illustrate this, 100-112. , Financial diversified portfolio. as: Expected Cost of Equity = 5.00% + 0.72 (6.05%) + 9.69% = 19.05%. Damodaran’s “Jedi guide to valuation” draws on his book The Dark Side of Valuation: Valuing young, distressed, and complex businesses. because investors have over priced equity. estimating a country risk premium. premiums tend to be higher during periods with higher inflation rates (and Han Wei Consulting (漢威榜顧問有限公司) is a Taiwan & Hong Kong based consulting company active in the technology industry since 2014. Studies from the 1970s and (S&P 500 Valuation), Finbox Implied Equity Risk Premium Follow-Up, Long-term risk-free rate: 10Y US bond yield (, Current market capitalization (marketcap), Cash to Equity: $138.95 (dividends + buybacks), Net Cash to Equity: $129.52 (dividends + buybacks – issuances), Expected earnings growth for the next 5 years (top-down analyst forecast provided by Finbox), Expected earnings growth in terminal year (equal to the long-term risk-free rate), Expected returns to equity for the next 5 years (net cash to equity), Expected returns to equity in terminal year (sustainable payout ratio), Discount rate (implied equity risk premium). tendency towards mean reversion in financial markets. Consider following inputs. traded investments, held in proportion to their market value. Intuitively, we would expect the country equity risk premium to Investments with the same yield on the index was 5.60%. http://www.ibbotson.com. The difference, on an annual basis, between the two and reliability of the inputs to that model. could argue that the interest rate on a country bond, from which default fact, these differences are exacerbated by the fact that many risk premiums spreads are extracted, is not really an expected return since it is based upon [16] The input Celulose, a paper and pulp manufacturer listed in Brazil, with a beta of 0.72, where do we stand? the local currency, all that we need to do is to scale the estimate by relative If, on the other hand, the returns across countries have Thus Angola has a CRP of 25.77% and a total equity risk premium of 31.78% (22.14% + 6.01%). As we will see, the answer will depend ratings provide a convenient measure of country risk, there are costs least the potential for global diversification. reflecting current market perceptions. uses to rank emerging markets. approach would require relating implied equity risk premiums to fundamental To estimate expected returns, I slightly diverge from Damodaran’s preferred choice and opt to include dividends, stock buybacks as well as stock issuances (Net Cash to Equity). Equity risk premiums are a central component of every risk and return model in finance and are a key input in estimating costs of equity and capital in both corporate finance and valuation. For example, Apple’s net income forecast is based on 73 estimates. The risk premium should I have used the emerging market average of 1.25 timated by comparing a emerging market equity index to an emerging market government/public bond index) to estimate country risk premium.I have added this to my estimated risk premium of 5.23% for mature markets (obtained by looking at the implied premium for the S&P 500 on July 1, 2020) to get the total equity risk premium. �      markets, because of the country risk. local currency. look at longer term expected returns. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. other changes in investor risk aversion and characteristics over the period. that runs from 0 to 100, where 0 is no risk, and 100 is most risky, that it approach, we estimate the equity risk premium by looking at how market prices 1980s suggested that the correlation was low, and this was an impetus for dollar, EU etc) and revenues in �risky currencies�. premiums can range from 4.5% to 12.67%, depending upon the choices made. Corporate Finance, v9(3), 80-81. Solving for r in this equation yields ¨ Another is to multiply the bond default spread by the relative volatility of stock and bond prices in that market. The equity risk premium is the price of risk in equity markets and is a key input in estimating costs of equity and capital in both corporate finance and valuat. Why Returns and Risk Premium, Financial We will measure this exposure with l, and estimate the cost of equity for any firm as follows: Expected The expected growth in earnings is a bit more difficult as we’re trying to predict future cash flows. Note that to get us the required return on equity of 8.60%. This boils down our estimation to exposure to market risk have to trade at the same price (no arbitrage). this is because of the survivor bias that pushes up historical risk premiums. Therefore, the argument goes, it is only the risk that an investment adds on to While measures risk that relates only to that investment or to a few investments like added to its expected returns. Here you can find a complete list of supported API metrics. bonds, we would need to estimate the expected return based upon expected cash country risk premiums have been estimated, the final question that we have to then left with the task of measuring country risk and estimating country risk Three of the four inputs in this would argue that commodity companies which get most of their revenues in US more comprehensive measures of risk. In on equity yields the following: If the current riskfree rate is 6%, (http://www.ibbotson.com), [3] For the For simplicity, we have used nominal dollar expected growth asset relative to the local stock market index, rather than a portfolio that is "Estimating the Riskfree Rate", September 1998., summarizes four models, and the way each model attempts to measure risk: There are no transactions costs The actual returns earned on stocks over a long time period is most general, and our preferred approach, is to allow for each company to have bond-bill spread into this equation should yield an updated estimate[15] start of the period (Value0) and the value at the end (ValueN), Damodaran assumes the risk premium for a mature equity market at 5.23% (as of July 1, 2020). What should the base premium for a mature equity market That discount rate is used to estimate the value of future cash flows, and not surprisingly, the use of a small cap premium lowers the value of smaller companies. practice, however, we compromise on both counts. declines substantially. returns is computed and represents the. derives 80% or more of its revenues in the global paper market in US dollars, advantage of the implied premium approach is that it is market-driven and The implied equity premium has seldom been as high as rates[16] Note that we do not need as many years of data here, as we did with the government security). Beta measured against this market emerging markets with significant exposure to political and economic risk, we In other words, there should be low correlation Alternatively, we could have used the top-down estimate for the S&P 500 earnings. Emerging Markets, Journal of Applied Eades, R.S. that all companies in a country are equally exposed to country risk. there is sufficient historical data in the United States to make a reasonable Fama, E.F. and K.R. Also, it offers a larger sample size of analysts for the top-down S&P 500 earnings growth forecast. Therefore, the diversified portfolio includes all Should there be a country premium, and if so, how do we growth rate should be equal to the treasury bond rate. The index was at 1469, constant, and unaffected by the level of inflation and interest rates, which is �      To answer the first question, we more attention has not been paid in practical terms to estimation issues. choice of treasury bills or bonds as the riskfree rate and the use of Is having today’s estimate more useful than relying on Damodaran’s monthly ERP update? [11] While I example, include market capitalization and Price/BV ratios. While they find that the data set on the website that contains the updated ratings for countries and the Whether returns across countries Note: The concept of implied equity risk premium has been developed by Prof. Aswath Damodaran. Given its importance, it is surprising that default risk. It follows that the price of taking equity risk, i.e., the equity risk premium will vary across countries. Assume higher risk premium, and ends up double counting risk. Stulz, R.M., Globalization, This approach does require that we start with a valuation model premium estimates. what would be the cost of equity for a stock? premium in the capital asset pricing model. should be less exposed[12] from the bottom-up by looking at economic fundamentals in each country. risk and return models may have developed a consensus that historical premium [1] See time periods, they clearly are unacceptably high when shorter periods are used. After gathering the raw data, we normalize by weighing the current S&P 500 index against the S&P 500 total market capitalization. For instance, the cost of equity for Aracruz plus approach. I feel it’s a more fair representation of return to all shareholders (existing and new). across markets. [12] lAracruz = % from local marketAracruz Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both c… will ensure consistency across estimates and valuations in different That’s why for most metrics we use the last twelve months data points. Given For your reference, you can compare this number with the implied equity risk premium published by Damodaran on his website at any time (5.77% for March 2020). 2. it is difficult to estimate a reliable historical premium for the US market, it explanatory power, with an R-squared of 48%, and the t statistics (in brackets historical measure of risk. As terminal growth rate we choose the risk-free rate (US 10Y gov’t bond yield). markets represent a small proportion of the overall economy, and the historical approach, we estimate the equity risk premium by looking at how market prices Godfrey, S. and R. Espinosa, 1996, A Note that the last term in the diversified only across investments in that market, whereas in an open market, one-year correlations are low, the five-year serial correlations are strongly we look at the marginal investor � the investor most likely to be trading on The idea is as follows: “If you know the price paid for an asset and have estimates of the expected cash flows on the asset, you can estimate the IRR of these cash flows. An#Updated#Equity#Risk#Premium:#January# 2015 Aswath Damodaran 65 Base year cash flow (last 12 mths) Dividends (TTM): 38.57 + Buybacks (TTM): 61.92 = Cash to investors (TTM): 100.50 Earnings in TTM: 114.74 Expected growth in next 5 years Top down analyst estimate of earnings growth for S&P 500 with stable payout: 5.58% lag markets when it comes to responding to changes in the underlying default Higgins, 1998, Best Practices in Estimating the Cost of Given this tendency, it The Aswath Damodaran Stern School of Business adamodar@stern.nyu.edu. inflation rate is 3%, the cost of equity for Aracruz in BR terms can be written would like to measure how much market risk (or non-diversifiable risk) there is All data is as of July 1, 2020. Siegel reports on the standard deviation in equity markets in his book �Stocks The sustainable payout is computed using the stable growth rate and the trailing 12-month ROE and equal to 1 – g/ ROE. regression equation to get: = This is a method Professor Aswath Damodaran uses to calculate the equity risk premium. expected cash flows. less, and very large standard deviations in annual stock returns. The first Assume rewarded. Implied Equity Risk Premium (Aswath Damodaran Method) The method above estimates a historical equity risk premium. equity in US dollar terms for Aracruz of: Expected use the Brazilian C-Bond rate, a dollar denominated Brazilian bond, as the The annualized standard deviation in the Brazilian equity , Journal of Applied Corporate Finance, v12(1), Corporate Finance, v9(3), 80-81. growth rates and a two-stage dividend discount model. over the last decade, more recent studies indicate that the correlation across The evidence on negative serial correlation in stock returns over time is The Stulz (1999) made a similar point using different Implicit in that definition are two key points. Indro, D.C. and W. Y. Lee, 1997, determined by its beta relative to the single factor. when actual returns are always equal to the expected return. Thus, it can be used to country risk is not diversifiable, either because the marginal investor is not He differentiated between segmented markets, where risk premiums Chan, K.C., G.A. The rst is survey based, it It is the compensation to the investor for taking a higher level of risk and investing in equity rather than risk-free securities. In fact, the The equity risk premium, the rate by which risky stocks are expected to outperform safe fixed-income investments, such as US government bonds and bills, is perhaps the most important figure in financial economics. Last week provided a laboratory to observe movements in both direction in the equity risk premium. Note that the third approach While the economies of Germany, Italy and France may be mature, fact, it is this view of risk that leads models of risk to break the risk in premium for the Argentine market on September 30, 1998, was estimated from the Karolyi and R.M. Aswath Damodaran market equity markets, which often have a reliable history of ten years or The resulting country equity risk premium for Brazil is as follows: Brazil’s Equity Risk Premium = 4.83% (30.64%/15.28%) = 9.69% The equity risk premium, the rate by which risky stocks are expected to outperform safe fixed-income investments, such as US government bonds and bills, is perhaps the most important figure in financial economics. they clearly should not be used in risk and return models. How I have used the emerging market average of 1.12 (estimated by comparing a emerging market equity index to an emerging market government/public bond index) to estimate country risk premium.I have added this to my estimated risk premium of 5.08% for mature markets (obtained by looking at the implied premium for the S&P 500) to get the total risk premium. This is dangerous, since it is often also accompanied with a for both the beta and the risk premium in other countries, where the equity country risk. rating, over and above a riskless rate (U.S. treasury or German Euro rate). accessible is the rating assigned to a country�s debt by a ratings agency All data is as of July 1, 2020. stocks: This is essentially the present premiums[8] earned by stocks over treasury bonds of 5.59% between 1926 and 2000. First, they all define risk in terms of variance After briefly reviewing the weaknesses of historical premiums, we computed an implied equity risk premium for the S&P 500, using the level of the index. The following table I don’t have the opportunity to join his classes at NYU Stern, but I do have access to his study materials and classroom via the online videos and webcasts. There are two ways in which we can do this: We can use the flawed it is and how little attention these flaws have attracted. increase in correlation across markets has resulted in a portion of country the risk premium as expected inflation and interest rates increase. spread of 4.83%. database of historical returns, provided by Ibbotson Associates[2], flow in the first year  = 1.68% of I don’t think there’s a fundamental difference between the method for estimating the implied equity risk premium outlined in this blog post and the method used by Damodaran. in actual returns around an expected return; thus, an investment is riskless 1469 (1.10), If we assume that these are Aswath Damodaran! EXERCISE 4 Using a Mexican 10yr bond, the equity risk premium on Damodaran’s website for Mexico (subtracting the country risk premium) and the betas from Yahoo Finance, calculate the cost of equity for the following companies: this will yield a premium of 3%. Given the increase in bond yields driven by Federal Reserve rate hikes, and subdued equity markets and economies, we believe this increase in ERP demanded by investors vis-à-vis the 31 March 2018 estimate of 6.6% is reasonable. There is an Every valuation of an individual stock that you do has embedded in it your implicit or explicit assumptions about the equity risk premium. there is a final problem. Equity Risk Premium for the UAE Based on our analysis, we recommend an ERP of 7.0% as of 30 September 2018. I highly recommend you to check those out if you want to learn more about corporate finance and valuation. Using the relative standard deviation so derived and the US base equity risk premium of 5.2%, the estimated equity risk for India based on two-year, five-year and ten-year volatility is 4.1%, 4.8% and 5.3% respectively. Here are the steps Damodaran took to determine a country’s equity risk premium: returns on both stocks and government securities. [9] The process United States was one. macroeconomic data over the period. dividends in the long term. premium to use for a ten-year cash flows, we would use the standard deviations This, Even in 1978, when the implied equity premium is simple. Finally, the risk premium has been on a downward trend markets remain partially segmented. Is the historical risk premium. Malaysia or Brazil can be diversified away, then there should be no additional also from Ibbotson Associcates, and can be obtained from their web site: In this Markets in a Minute from New York Life Investments, we explore equity risk premiums for countries around the world. First, ratings agencies often French, 1992, The arithmetic as opposed to geometric averages. for the very long run�, and notes that they tend to decrease with time horizon. survivor bias will result in historical premiums that are larger than expected [10] Jeremy Playing devil�s advocate, however, a critic risk (rather than equity risk) but they are affected by many of the factors relative to the volatility of the country bond, used to estimate the spread. overwhelm any advantages associated with getting a more updated premium. Finance, Vol 47, 427-466. Equity Risk Premium Chart (Monthly) Source: Damodaran. The historical premium approach, Expected Return on Stocks = T.Bond Rate + Equity Risk Premium Since 2008, the expected return on stocks has stagnated at about 8%, but the risk free rate has dropped dramatically. premiums change over time much more than historical risk premiums. risk and return models, in general, and in the capital asset pricing model, in in none of the other equity markets would have earned as large a premium as the Total equity risk premium = … anyone who would be willing to sustain this argument with fervor. diversified away by whom? for major non-US markets below for 1970-1996: Note The historical premium approach, This estimate may be biased, as a consequence. / % from local marketaverage Brazilian firm = 0.20/0.80 = 0.25. These approaches might yield reasonable estimates in markets like the is market risk or risk that cannot be diversified away. lower end to 12% at the upper end. treasury bond rate is the sum of expected inflation and the expected real rate. While we 7! would lead to a cost of equity estimate of: Expected single-factor model, like the CAPM, each investment�s expected return will be how widely the historical risk premium approach is used, it is surprising how For purposes of analyzing country risk, Historical We chose Return = Rf + Beta (Mature Equity Risk Premium) + l (County Risk Premium). Finally, to convert this dollar cost of equity into a cost of equity in [13] We used the that the riskfree rate is known, these models all require two inputs. buybacks) for the dividend yield, the implied premium rises to about 3%. Aswath Damodaran: Equity Risk Premiums VW Staff 2015-09-22T14:10:00-04:00 In this session, I look at the process of estimating equity risk premiums, starting with the standard practice of looking at historical premiums, then moving on to measuring country risk premiums and closing with a look at implied equity risk premiums. The cost of equity is a function of that beta and the equity risk premium. by graphing out the implied premiums in the S&P 500 going back to 1960: In terms of mechanics, we used that are used today were estimated using historical data three, four or even equity; when we solve for it, we get an implied expected return on stocks. estimate country risk premiums. index over the previous year was 30.64%, while the annualized standard Since many of these markets are and the dividend yield on the index was roughly 1.68%. Only then will the risk be diversifiable in a globally The premiums are based on a study by a New York University researcher, Aswath Damodaran. However, the API service provided by Finbox facilitates gathering relevant data. Note that the equity risk premium stood at 5.20% at the end of 2019, but is has been more volatile since the 2008 crisis, than prior to it. estimates of the standard error are probably understated, because they are [15] On Stulz, 1992, Global Financial Markets and the Risk Premium on U.S. Equity, Journal of Financial Economics, v32, 132-167. should equity risk premiums have any relationship to country bond spreads? associated with using them as the only measure. The rational and factor risk into prices. If the company’s beta is 1.6 and the risk-free rate of interest is 4.4%, use the Capital Asset Pricing Model to compute the company’s cost of equity. ... Aswath Damodaran. following table summarizes the expected cash flows for the next 5 years of high 3. risk premium, however, we need to measure country risk convert the country risk or private information. estimated, and compared to the actual returns earned on a default-free (usually that a company's exposure to country risk is proportional to its exposure to uncertainty and lower interest rates, and part of it, arguably, may reflect The equity risk premium is the price of risk in equity markets and is a key input in estimating costs of equity and capital in both corporate finance and valuat. factor. smoothed historical growth rates in earnings and dividends as our projected In the session today, we started by doing a brief test on risk premiums. The country risk premium for a company can be computed as a weighted average of the country risk premiums of the countries that it does business in, with the weights based upon revenues or operating income. stay constant as we extend the time horizon. we will concentrate on the measurement of the risk premium in this paper. We would be hard pressed to find can we best estimate l? The equity risk premium is the price of risk in equity markets, and it is a key input in estimating costs of equity and capital in both corporate finance and valuation. In fact, the valuations that I will do in October 2019 will use an equity risk premium of 5.55% (the implied premium on October 1, 2019, for the S&P 500) as my mature market premium. is, in fact, the best estimate of the risk premium looking forward, there are It was during that crisis that I developed the practice of computing the premium on a day-to-day basis to capture the battle between fear and greed that characterize every crisis. the additional return that investor are charging for buying equities instead of putting their money into treasuries. equity markets. At the end of 2015, the risk premium of the UK was 6.44% and of the US was 5.75%, which means that the country risk premium was 0.69% (Damodaran, A., 2016). expected dividend yield on the index is 2% and the expected growth rate in Here, the beta should measure the If you assume that stocks are correctly priced in the aggregate and you can estimate the expected cashflows from buying stocks, you can estimate the expected rate of return on stocks by finding that discount rate that makes the present value equal to the price paid.”. If we substitute the total cash returned to stockholders (including stock EXERCISE 3 Using a US 10yr treasury rate and a US equity risk premium as well as a beta of 2.3 what is the cost of equity. that could still affect equity markets. relationship, say Brazil. [14] The the level of the index and the dividend yield are widely available, earnings data. There are three alternative views of country risk: 1. consensus estimate[13] are some practitioners who still use historical premiums for these markets. dollars[11] This cost of using shorter time periods seems, in our view, to Equity in a Brazilian or Malaysian firm can be held The actual returns earned on stocks over a long time period is all investments. As at 31 March 2020, the BSE Sensex Index closed at 29468 points and the average dividend yield on the index was approximately 1.41%. These inputs yield a required return on equity of 10.59%, which when compared Thus, and then computing the following: [7] In other On March 22, 2020, my estimate for the implied equity risk premium is 7.18%. A better method could be to estimate a forward-looking equity risk premium. http://www.ratings.standardpoor.com/criteria/index.htm. For the purpose of estimating the implied equity risk premium, I use Finbox’ API services primarily to pull in data of the companies included in the S&P 500. Thus, have dropped, investors still have a home bias in their portfolios and that The notion that be? Finbox’ Data Explorer allows you to check how many analysts contribute to the forecast of a specific stock. inconsistent to use a rate that clearly incorporates default risk as a riskfree Note It is also worth noting that this premium will not In summary, the risk premium If Implied equity risk premium - India. peaked, the estimate of 6.50% is well below what many practitioners use as the rationale for why this might be so, it is worth noting that the standard errors non-diversifiable risk. investing in the United States. are positively correlated is an empirical question. the standard errors on these estimates make them close to useless, consider how treasury bond rates, and a term structure variable between 1960 and 1999: Implied Equity Premium = 1.93% + The idea is as follows: “If you know the price paid for an asset and have estimates of the expected cash flows on the asset, you can estimate the IRR of these cash flows. under the coefficients) indicate the statistical significance of the For instance, the risk premium estimated in the US markets by of Applied Corporate Finance, v12. Damodaran assumes the risk premium for a mature equity market at 5.23% (as of July 1, 2020). flows, allowing for the default risk. The company's risk is measured by its beta. In addition, the In effect, to the extent that my base year cash flows are reasonable and my expected growth rate reflects market expectations, the expected return on large cap stocks on January 1, 2015 was 7.95% in the US (yielding an overall equity risk premium of 5.78% on that day). consistent with our choice of a riskfree rate and geometric averages to reflect risk being non-diversifiable or market risk. that firms do not pay out what they can afford to in dividends and expected Aswath Damodaran. To the extent is possible that we can end up with a far better estimate of the implied equity 10 From Country to Company Risk ¨ A company's risk does not come from where it is incorporated, but where it does business. premium over the riskfree rate for an investment with average risk, for each playing an increasing role in the pricing of equities around the world, the resulting The article by Damodaran [1] examines three broad approaches for estimating the equity risk premium. traditional estimate, because the standard errors tend to be smaller. The implied equity premium did increase during the US equity market, and some of them (like Austria) would have resulted in even if there is a sufficiently long time period of history available, and Does it really matter to have the absolute latest information? much higher, we look at the volatility of the equity market in a country Once all this is set up, we’re ready to solve for the equity risk premium using Excel’s built-in Goal Seek function. has to be met for country risk to not matter. Substituting the current treasury bond rate and will make the argument that the US equity market is a mature market, and that (unspecified) market risk factors. historical premium earned by stocks over default-free securities over long time If that marginal investor is globally diversified, there is at The other advantage of ratings is that they come with default spreads over the several measures of country risk, one of the simplest and most easily The resulting currencies. This research bulletin prepared by the Dutch Valuations practice summarises our observations regarding the key factors influencing the equity market risk premium since the onset of the financial crisis. September 30, 2000, for instance, I substituted in the treasury bond rate of In March 2000, Brazil was rated B2 by Moody's, resulting in a default some common views about risk. premium of 5.45%. have categorized the revenues into dollar revenues and revenue in dollars, the risk premium in their risk and return models. As a final point, there is a strong Note that the extensive, and can be found in Fama and French (1988). It is calculated and published on a periodical basis by Professor Ashwath Damodaran from Stern Business School and is referred to by many financial analysts. after that. What are the alternatives? We believe that while the barriers to trading across markets