Equity premium is also known as Equity risk premium. It is the excess return that one gets when investing in the stock market over the return from a risk-free rate. The premium varies with the level of risk involved, and it changes as the market fluctuates.
There are three main steps used to calculate the equity risk premium.
Estimate the expected return on stock
Estimate the return on safe bond
Subtract the difference between the two to arrive at equity premium
Estimate the Expected Return on Stock
This step involves forecasting the value of stock in the long run. It is the most difficult step in the process of estimating equity risk premium. The dividend-based approach or the earning model is used to predict the return on stock.
Earning based approach
This method assumes that the earnings yield and the expected return are equal.
K is the expected return
E is the earnings per share
P is the stock price
Graph illustrations are used to compute the index figure. Let’s say a company has earnings per share (EPS) of $45.20 and an index of 1112. To calculate the price to earnings ratio, you divide the EPS with the index. The P/E multiple is 24.6. The earnings yield is calculated as (1/25 = 4%). Note, the P/E multiple has been rounded off to the nearest number. When the P/E value is high, it means there will be lower returns, but if the value is low, then there will be higher returns.
The expected return on the stock is predicted to be equal to the growth in dividends plus the dividend yield. Assume a company gets a dividend yield of 1.56% in 2015. To compute the expected returns on stock, add a forecasted growth of dividend per share. To get the value, it is assumed that dividend growth and economic growth go hand in hand. For that reason, the GDP, per capita GNP or the Gross National Product is used.
Let’s say the compilation relies on GDP. That means that if GDP grows by 4%, then the expected returns on the dividend is also 4%. This is not possible due to two reasons;
The dividend yield approach focuses on per share growth, but unfortunately, most companies issue stock options as a way of diluting their share base.
Private entrepreneurs create an unequal share of economic growth; public markets are almost dormant in the economy’s rapid growth.
For that reason, then previously proven statistics are used. For example, a GDP growth of 4% goes hand in hand with a dividend per share growth of between 3% – 2%. To get the return on stock, we add the growth forecast (2-3%) to the dividend yield (1.56%).
1.56% + 2% = 3.56%
If we use 3%, we get, 1.56% + 3% = 4.56%
The value ranges between 3.56% and 4.56% which is close to what the income yielding method predicts.
Estimate the return on risk-free rate
If you want to invest in a risk-free investment for a long time, then the TIPS (Treasury Inflation Protected Security) is the best option. The principal and coupon payments are adjusted two times in a year for inflation. Though the bonds are called risk free, they have some risks.
The price of the bond moves up or down when the interest rates move up or down. Regardless of this, the return on the bond is high if you hold it until it matures. For a ten-year yield bond with the real yield of 2.3% and a TIPS yield of 2%, the future return on the bond is 2%.
Subtracting estimated stock return from bond return to get equity premium
The stock on returns is 3.5% to 4.5% while the return on the bond is 2%.
So, 3.5% to 4.5% subtract 2% = +1.5% to 2.5%
Assumptions of the model
The model calls for the growth in dividend per share to be a low single digit.
The model assumes that the stock market will always perform better than the risk-free securities in the long run.
It also assumes that existing valuation levels are approximately correct.