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Unformatted text preview: Aswath Damodaran 1 Equity Risk Premiums: Looking backwards and forwards… Aswath Damodaran Aswath Damodaran 2 What is the Equity Risk Premium? Intuitively, the equity risk premium measures what investors demand over and above the riskfree rate for investing in equities as a class. It should depend upon • The risk aversion of investors • The perceived risk of equity as an investment class Aswath Damodaran 3 How equity risk premiums lose their meaning… Model Expected Return Inputs Needed CAPM E(R) = R f + β (R m R f ) Riskfree Rate Beta relative to market portfolio Market Risk Premium APM E(R) = R f + Σ j=1 β j (R j R f ) Riskfree Rate; # of Factors; Betas relative to each factor Factor risk premiums Multi E(R) = R f + Σ j=1,,N β j (R j R f ) Riskfree Rate; Macro factors factor Betas relative to macro factors Macro economic risk premiums Proxy E(R) = a + Σ j=1..N b j Y j Proxies Regression coef¡cients Aswath Damodaran 4 Why equity risk premiums matter… Every statement about whether equity markets are over or under valued is really a statement about the prevailing equity risk premium. Every valuation of an individual stock that you do has embedded in it your implicit or explicit assumptions about the equity risk premium. To the degree that your equity risk premium is incorrect, every valuation that you do will be contaminated. All asset valuations have implicit risk premiums built into them. Getting the premium wrong will lead to misvaluations. Aswath Damodaran 5 What is your risk premium? Assume that stocks are the only risky assets and that you are offered two investment options: • a riskless investment (say a Government Security), on which you can make 4% • a mutual fund of all stocks, on which the returns are uncertain How much of an expected return would you demand to shift your money from the riskless asset to the mutual fund? Less than 4% Between 4 6% Between 6  8% Between 8 10% Between 10  12% More than 12% Aswath Damodaran 6 Risk Aversion and Risk Premiums If this were the capital market line, the risk premium would be a weighted average of the risk premiums demanded by each and every investor. The weights will be determined by the magnitude of wealth that each investor has. Thus, Warren Bufffet’s risk aversion counts more towards determining the “equilibrium” premium than yours’ and mine. As investors become more risk averse, you would expect the “equilibrium” premium to increase. Aswath Damodaran 7 How equity risk premiums are estimated in practice… Survey investors on their desired risk premiums and use the average premium from these surveys....
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 Summer '10
 Aswath

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