Equity risk premiums are useful. But can they alone tell whether the market is over- or under-valued? We take a closer look in the below article…

A fellow student in the online valuation class of NYU recently requested my thoughts on a report from a top bank regarding equity risk premiums (“ERP”). The crux of the report was that since ERPs across most developed nations are higher than their past average, markets are under-valued and that everything was ok.

In my view, one needs to be careful of forming an opinion about markets based on only one metric. If that were true, all you would have to do is to keep track of that metric and invest based on it. Although ERP is a very informative metric, in the following response I argue why it should not be blindly followed:

Hi _____,

Before I delve into my thoughts on your question, let me first briefly set out what the ERP means. ERP is the price of investing in equities as a class – It is an accumulation of every hope and every fear regarding equities in the markets.

ERP is affected by changes in the following four inputs:

  • Level of the index;
  • Existing cash flows;
  • Growth in cash flows; and
  • Risk-free rate.

With the very basics of ERP out of the way, let me try and answer your queries. I am not sure how XYZ calculates ERP but Prof. Damodaran’s ERP for the US market currently stands at 5.13%. However, this ERP is based on a payout ratio of more than 100% (since current dividends and buy-backs of US companies exceed current earnings). To that extent this ERP may be overstated. The Prof. also calculates a more reasonable ERP where he normalises earnings and gradually reduces the payout ratio to a more sustainable level by year 5. This adjusted ERP is currently around 4.23% which is not very different from the long-term average. So, it is quite possible that XYZ is looking at the higher of the two ERPs.

That said, I think one should not focus on the ERP alone to gauge whether the market is over- or under-valued. It is more interesting to look at the relation between the ERP and the expected return on equity over the past decade. I am reproducing below a chart from Prof’s. website where he breaks the expected return on equity between its risk-free and ERP component.

Screen Shot 2017-07-25 at 11.32.30 am

As you would note, for much of the past century, the expected return on equity was dominated by the risk-free component, which has started to change in the last decade. Today, the ERP constitutes a major chunk of the expected return given the low interest rate environment. One way to think about this is that equities are a lot riskier today since most of your return is dependent on the ERP. If risk-free rates were to normalize let’s say at 5%, it is very much possible that the ERP contracts (to around 2%) to maintain the same expected return. That contraction in ERP would not lead to higher index values since the discount rate remains unchanged. But that would make equities unattractive since there won’t be enough of a premium over the risk-free rate (as compared to history). If, however, the ERP was to remain constant along with an increase in risk-free rates, the discount rates would go up which would lead to a correction in prices unless cash flows and future growth prospects were to improve.

These are two extreme scenarios with the unrealistic assumption that changes in one of the inputs has no effect on the others. In reality, changes in risk-free rates will affect growth expectations which will consequently affect the level of the index. Therefore, a change in ERP will depend on the cumulative effect of the changes in the inputs affecting the ERP.

Since there are many moving parts which determine the course of the ERP, one would need to keep an eye on all of them to gauge what could happen. A judgment about stocks by simply comparing the ERP to historical averages would not be fair in my opinion.

As you can see, ERP is a complicated topic and I hope this has been useful.

Cheers!

Source : Implied ERP and risk-free rates  –  http://pages.stern.nyu.edu/~adamodar/

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