their risk and return models. In fact, the average implied
equityriskpremiumhasbeenbetweenabout 4 percentover
the past 40 years.
2.Theimpliedequitypremiumdidincreaseduringthe1970s
asinflationincreased.Thisdoeshaveinterestingimplications
forriskpremiumestimation.Insteadofassumingthattherisk
premiumisaconstantandunaffectedbythelevelofinflation
andinterest rates,which iswhatwedowith historicalrisk
premiums, it may be more realistic to increase the risk
premium as expected inflation and interest rates increase.
Whenanalystsareaskedtovaluecompanieswithouttakinga
pointofviewontheoverallmarket,theyshouldbeusingthe
current implied equity risk premium. Using any other
premiumbringsaviewonmarketsintothevaluationofevery
stock. In January 2006, for instance, an analyst usinga 5
percentriskpremium inthevaluationofa companywould
effectively have been assuming that the market was
overvaluedbyroughly 20 percent.(Theimpliedequityrisk
premium inJanuary 2006 was4.08 percent;gettingto a 5
percentpremiumwouldhaverequiredthattheS&P 500 be 20
percent lower.)
Beta
Thefinalsetofinputsweneedtoputriskandreturnmodels
intopracticearetheriskparametersforindividualassetsand
firms.IntheCAPM,thebetaoftheassethastobeestimated
relativetothemarketportfolio.IntheAPMandmultifactor
model,thebetasoftheassetrelativetoeachfactorhavetobe
measured.Therearethreeapproachesavailableforestimating
these parameters; one is to use historical data on market