Note that the term with 42.33 in the last term of the equation is the terminal value of
the index, based on the stable growth rate of 6.5%, discounted back to the present.
Solving for rin this equation yields us the required return on equity of 8.56%. The
Treasury bond rate on December 31, 1999, was approximately 6.5%, yielding an im-
plied equity premium of 2.06%.
The advantage of this approach is that it is market-driven and current and it does
not require any historical data. Thus, it can be used to estimate implied equity premi-
ums in any market. It is, however, bounded by whether the model used for the valua-
tion is the right one and the availability and reliability of the inputs to that model. For
instance, the equity risk premium for the Argentine market on September 30, 1998,
was estimated from the following inputs. The index (Merval) was at 687.50 and the
current dividend yield on the index was 5.60%. Earnings in companies in the index are
expected to grow 11% (in U.S. dollar terms) over the next 5 years and 6% thereafter.
These inputs yield a required return on equity of 10.59%, which when compared to the
treasury bond rate of 5.14% on that day results in an implied equity premium of
5.45%. For simplicity, we have used nominal dollar expected growth rates^12 and Trea-
sury bond rates, but this analysis could have been done entirely in the local currency.
(c) Betas. In the CAPM, the beta of an investment is the risk that the investment
adds to a market portfolio. In the APM and multifactor model, the betas of the in-
vestment relative to each factor have to be measured. There are two approaches avail-
able for estimating these parameters. The first is to use historical data on market
prices for individual investments. The second is to estimate the betas from the fun-
damental characteristics of the investment.
(i) Historical Market Betas. With historical market betas, we use past data on stock
returns and returns on a market index to estimate the beta for a firm. In this section,
we will first describe the standard approach and then talk about some of the limita-
tions of using it in emerging markets.
9 • 16 VALUATION IN EMERGING MARKETSYear Cash Flow on Index
1 27.15a
2 29.86
3 32.85
4 36.13
5 39.75
6 42.33
aCash flow in the first year = 1.68%
of 1469 (1.10)Exhibit 9.3. Estimating an Implied Equity Risk Premium.
(^12) The input that is most difficult to estimate for emerging markets is a long term expected growth rate.
For Argentine stocks, I used the average consensus estimate of growth in earnings for the largest Argen-
tine companies that have listed American Depository Receipts (ADRs). This estimate may be biased, as
a consequence.