What to Use as the Equity Risk Premium?

I'm teaching Corporate Finance again this semester. In the class, we spend a fair bit of time on the CAPM (yes, I know - it's not perfect. But it is a still pretty good). One of the big issues is what to use as the Market Risk Premium (or, as it's sometimes called, the "Equity Risk Premium). Looks like I'll be using this piece as background: The Equity Risk Premium in 100 Textbooks by Pablo Fernandez of the University of Navarra. Here's the abstract:

I review 100 finance and valuation textbooks published between 1979 and 2008 (Brealey, Myers, Copeland, Damodaran, Merton, Ross, Bruner, Bodie, Penman, Weston, Arzac...) and find that their recommendations regarding the equity premium range from 3% to 10%, and that several books use different equity premia in different pages.

Some confusion arises from not distinguishing among the four concepts that the word equity premium designates: Historical equity premium, Expected equity premium, Required equity premium and Implied equity premium.

Finance professors should clarify the different concepts of equity premium and convey a clearer message about their sensible magnitudes.

It's worthwhile reading - you can download the full version on SSRN here.

HT: Jim Mahar at FinanceProfessor.com

Comments

[Pink Panther:]

Thank you for the link, quite interesting read...

The problem I have with the CAPM is that essentially risk is defined as standard deviation from past performance.
As an investor, I don't care too much about standard deviation or volatility of my investments as long as I can buy them "low".
A much better interpretation of risk would be the estimation of balance sheet risk, earnings risk and valuation risk of a security (or of a market).

Sep 01 03:18 PM

[seasaw:]

I disagree completely with the way Corporate Finance is taught at virtually all of top universities in the country. I had studied investing for many years, reading Graham, Fisher, Buffett, Klarman, Greenwald, Greenblatt, Whitman, and others. Then I started studying for the CFA exam and the textbooks introduced the concepts of modern portfolio theory - efficient market theory, cost of capital, CAPM, equity risk premium, beta, alpha, etc. These concepts made no sense to me. I then went back to Buffett, Munger, etc. to see their comments and they had the same view.
Consquently, I recommend that you develop your own curriculum and start your own book to properly teach corporate finance. You could teach the concepts in the textbook and then criticize them and propose better a proper analysis. Buffett has written extensively on the proper principles that appy to allocating capital.
You are doing a grave disservance to your students if you teach them the concepts in the current Corporate Finance books as if they concepts made sense and were correct. CAPM is not only not pretty good, it is nonsensical.
More specifically, a company has no idea what its stock price will be in the short term, so it can't have any specific "expected return". Likewise, a company really does not know most of the time what return on capital it will make on a new investment or project, so it can't have any expected rate of return for the project. The best you can do is have a generally idea or sense that the project is a good one and has a good chance of generating good returns. In other words, try to learn to make a estimate of the likliehood that the project will be successfull and try to estimate what kind of returns it will make if successfull (and the odds it will be unsuccessful and the likliehood of losses). You can get more detailed with odds of various scenaries of success and returns but it becomes less and less valuable the more detailed (better be roughly correct than precisely wrong).

do not make any sense at all, yet they are teaching them in the top graduate schools throughout the country.

Narrative:
I studied the works of Graham, Fisher, Buffett, Munger, Greenblatt, Greenwald, Klarman, and many others of similar ilk. I then started studying for the CFA exam. When I reached the sections about modern portfolio theory, cost of capital, CAPM, equity risk premium, etc., I thought that it made no sense at all. I went back to Buffett, Munger and others and they also thought these concepts were absurd.
I

Sep 02 07:57 PM