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ESTIMATING THE EQUITY RISK PREMIUM AND EQUITY COSTS: NEW WAYS OF LOOKING AT OLD DATA
Author(s) -
Booth Laurence
Publication year - 1999
Publication title -
journal of applied corporate finance
Language(s) - English
Resource type - Journals
eISSN - 1745-6622
pISSN - 1078-1196
DOI - 10.1111/j.1745-6622.1999.tb00665.x
Subject(s) - equity premium puzzle , equity risk , economics , risk premium , equity ratio , return on equity , econometrics , equity capital markets , bond , treasury , private equity fund , cost of equity , equity (law) , financial economics , cost of capital , private equity , finance , microeconomics , profitability index , geography , profit (economics) , archaeology , political science , law
This article examines three alternative ways of estimating the expected return on the equity market in using the CAPM or some other risk premium model. The three techniques are (1) direct estimation of the average nominal equity return for use as a forecast nominal equity return; (2) estimation of the average real equity return, which can then be added to a forecast inflation rate; and (3) estimation of an average equity risk premium, which is then added to a current risk‐free rate. Ibbotson and Sinquefeld's data on annual holding period returns are used to test the validity of their assumption that the equity risk premium follows a random walk and that the third of these approaches is thus the best method. The paper reaches three major conclusions. First, each of these three techniques involves a “bias” of some kind. The use of average equity returns as a forecast is subject to “risk‐free rate” and “inflation rate” biases, while the use of an average equity risk premium is subject to a “term premium” bias. As a result, only the data can tell us which approach is best. Second, from analyzing equity and bond return data and the trend in interest rates, the author concludes that the term premium bias when using average historic equity risk premium is by far the largest of the three sources of bias. Indeed, the popular practice of adding an historic average equity risk premium to the 30‐year Treasury bond rate significantly overstates equity costs. Third, after examining equity rates of return back to 1871, the author concludes that the real equity return seems to follow a process that is close to a random walk and is thus the “best” of the three techniques to use as a “naive” forecast.