Equity Risk Premium

Equity Risk Premium Article

Michael Annin, CFA and Dominic Falaschetti, CFA

This article appears in the January/February 1998 issue of Valuation Strategies. Executive Summary This article explores one of the most important elements in any discount rate calculation—the equity risk premium. While there are many topics in the area of finance upon which academics agree, a topic as basic as the equity risk premium still can produce some vigorous debate.

The assumptions that underlie the calculation of the equity risk premium have a material impact on the magnitude of the premium and, therefore, the ultimate discount rate. It is important for anyone performing business valuation to understand how and why any risk premium calculation is performed due to the impact it has on the overall valuation.

This article explores some of the more common equity risk premium methodologies currently in use by business valuation professionals. We attempt to address how the equity risk premium is calculated under each methodology and the assumptions that underlie each approach.

Introduction What is the equity risk premium? The equity risk premium is defined as the reward that investors require to accept the uncertain outcomes associated with owning equity securities. The equity risk premium is measured as the extra return that equity holders expect to achieve over risk-free assets on average.

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It is important to note that the equity risk premium as it is used in discount rates and cost of capital analysis is a forward looking concept. That is, the equity risk premium that is used in the discount rate should be reflective of what investors think the risk premium will be going forward.

There are two general ways to estimate the equity risk premium - one using historical data and one using estimates or market projections. Using historical data to develop an equity risk premium, one assumes that what has happened in the past is representative of...