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Equity Risk Premiums (ERP): Determinants, Estimation and Implications - A post-crisis Update October 2009 Aswath Damodaran Stern School of Business adamodar@stern.nyu.edu

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Equity Risk Premiums (ERP): Determinants, Estimation and Implications
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 andcapital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. We begin this paper by looking at the economic determinants of equity risk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating equity riskpremiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile.We look at two other approaches to estimating equity risk premiums – the survey approach, where investors and managers ar asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in non-equity markets. We also look at the relationship between the equity risk premium and risk premiumsin the bond market (default spreads) and in real estate (cap rates) and how that relationship can be mined to generated expected equity risk premiums. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the “right” number to use in analysis. (In an addendum, we also look at equity risk premiums during the market crisis,starting on September 12, 2008 through December 31, 2008, and then track the shift the changes through September 30, 2009.)

3 The notion that risk matters, and that riskier investments should have higher expected returns than safer investments, to be considered good investments, is both central to modern finance and intuitive. Thus, the expected return on any investment can be written as the sumof the riskfree rate and a risk premium to compensate for the risk. The disagreement, in both theoretical and practical terms, remains on how to measure the risk in an investment, and how to convert the risk measure into an expected return that compensates for risk. A central number in this debate is the premium that investors demand for investing in the ‘average risk’ equity investment, i.e.,the equity risk premium. In this paper, we begin by examining competing risk and return models in finance and the role played by equity risk premiums in each of them. We argue that equity risk premiums are central components in every one of these models and consider what the determinants of these premiums might be. We follow up by looking at three approaches for estimating the equity risk premium inpractice. The first is to survey investors or managers with the intent of finding out what they require as a premium for investing in equity as a class, relative to the riskfree rate. The second is to look at the premiums earned historically by investing in stocks, as opposed to riskfree investments. The third is to back out an equity risk premium from market prices today. We consider the plusesand minuses of each approach and how to choose between the very different numbers that may emerge from these approaches.

Equity Risk Premiums: Importance and Determinants
Since the equity risk premium is a key component of every valuation, we should begin by looking at not only why it matters in the first place but also the factors that influence its level at any point in time and why that...