Implied Equity Premiums
Thereisanalternativetoestimatingriskpremiumsthatdoes
notrequirehistoricaldataorcorrectionsforcountryrisk,but
doesassumethattheoverallstockmarketiscorrectlypriced.
Consider, for instance, a very simple valuation model for
stocks.
Thisisessentiallythepresentvalueofdividendsgrowingata
constantrate.Threeofthefourvariablesinthismodelcanbe
obtainedeasily—thecurrentlevelofthemarket(i.e.,value),
theexpecteddividendsnextperiod,andtheexpectedgrowth
rate in earningsand dividends in thelong term. Theonly
unknownisthentherequiredreturnonequity;whenwesolve
for it, we get an implied expected return on stocks.
Subtractingouttherisk-freeratewillyieldanimpliedequity
risk premium.
Toillustrate,assume thatthecurrentleveloftheS&P 500
indexis900,theexpecteddividendyieldontheindexforthe
next periodis 3 percent, and the expectedgrowth rate in
earningsanddividendsinthelongtermis 6 percent.Solving
for the required return on equity yields the following:
Solving forr,