Expected Risk premium (ERP) is the added return that investors expect to earn from investing in equity, which is riskier than investing in a risk-free instrument, such as T-bond. The equity risk premium plays a pivotal role in diversifying an investors’ portfolio between stocks and bonds. When investors have a more objective idea of the relative returns to stocks, bonds, and cash, it allows them to make better decisions about allocating their money into these assets.
The risk premium encourages investors to purchase riskier assets. Due to changes in economic growth, inflation and risk, ERP is a dynamic number that varies over time. The estimates of the equity risk premium differ as there are several approaches to calculating them.
A finance guru, professor of Finance at the Stern School of Business at NYU Aswath Damodaran, offers to apply the same technique that is used to calculate a bond’s yield to maturity for calculating the discounted present value of S&P 500 earnings.
Instead of factoring in the formula discounted values of the bond’s coupon cash flows over the bond’s lifetime, the cash flows take the form of dividends and buybacks discounted over the five-year period at the rate of 5,75%, which is the implied return on stocks and includes an ERP rate plus 1.51% risk-free T-bond rate. The calculation of ERP is based on the expectation that a fair ERP for the S&P 500 should be between 4% and 5%, and is 4.27% now, which is higher than the long-term historical average of 4.21%, but closer to the average ERP since 2008. It is assumed that these cashflows continue in perpetuity.
In his calculation, professor Damodaran factors in the discounted projected dividends and buybacks from S&P 500 earnings over the upcoming 5 years starting with the current year of 2022. The assumption made beyond the fifth year is based on the idea that the expected earnings and cash flows of the S&P 500 will grow at a 1.51% risk-free rate.
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