Equity Risk Premium (ERP)
Most of us have read in the finance class that ERP is 4 percent. Therefore to calculate the cost of equity one should multiply Beta to ERP and add this product to the Risk free rate. This is what the finance course has taught us in Capital Asset Pricing Model (CAPM). Having worked in different countries and traveled around the world, I hear experts say that companies should strive for 12% return. Even many CEOs on investor call have explicitly mentioned that they strive for 12% return.
I have asked many people on what this 12% return mean and why it should not be 15% or 9%. I was pleasantly surprised to see not many investment professionals were aware of what this 12% means.
Companies and Investors will benefit on understanding what and how this 12% is calculated.
I have briefly explored on some of the insightful articles, I have read over the years on this topic.
Refer article by Elory Dimson, Paul Marsh and Mike Staunton of LBS on ERP. They have written extensively on ERP. Refer http://papers.ssrn.com/sol3/papers.cfm?abstract_id=891620 . The synopsis is that this 4% is achieved over a very long period and across all companies. It includes companies which have done very well and have gone bankrupt. It is across recessions, bubbles and normal economic growth.
Beta is a backward looking concept and it does not tell about the future. James Montier has written extensively on this, I am hyper linking his blog, for summary on his thoughts about CAPM and Beta. Initiative Blog: CAPM is CRAP by James Montier.
Companies should abandon this 12% return as hurdle rate. Companies when deciding to invest should be aware of the limitations of this 12%. They should target for higher rate, when the economy is expected to perform better as when there is recession the returns will invariably be less. I have often seen companies when they make project plan, never presume there will be recession and target to earn 12% even in their optimistic times. Companies invariably suffer as during recessions or low economic growth their ROE will be less than 12%. Therefore they are not able to earn 12% over long periods of time.
Investors should also be aware of the cyclical nature of the business and countries economic growth. Investors when valuing the company using a discount rate of this 12% as expected return will be buying shares at a much higher price during economic growth times. The higher returns generated by the company will be mistaken for extraordinary strengths of the company and presume that these returns will go on for a long time. Companies having ROE above this 12% are quoted at a much higher premium as compared to other companies. Investors also will be missing opportunity when shares in the country experiencing recession are traded at a discount. During recessions investors presume that companies have ROE of less than 12% and this will be the return for a long time. Companies earning less than the Cost of Equity presumably this 12 % trade at discount.
There is no one metric to judge an overvalued or undervalued project or a company. Investors and companies should be aware of how and what ERP means and this 4% is over a very long period, across different industries and various business cycles.