CP

232 CHAPTER 6 The Cost of Capital

Forward-Looking Risk Premiums An alternative to the historical risk premium is to

estimate a forward-looking, or ex ante, risk premium. The most common approach is to

use the discounted cash flow (DCF) model to estimate the expected market rate of re-

turn,rˆMrM, and then calculate RPMas rM
rRF. This procedure recognizes that if

markets are in equilibrium, the expected rate of return on the market is also its required

rate of return, so when we estimaterˆM, we are also estimating rM:

In words, the required return on the market is the sum of the expected dividend yield

plus the expected growth rate. Note that the expected dividend yield, D 1 /P 0 , can be

found using the current dividend yield and the expected growth rate: D 1 /P 0 D 0 (1 

g)/P 0. Therefore, to estimate the required return on the market, all you need are esti-

mates of the current dividend yield and the expected growth rate in dividends. Several

data sources report the current dividend yield on the market, as measured by the S&P

500. For example, Yahoo! reports a current dividend yield of 1.78 percent for the S&P


501. Yahoo! also reports a 9.03 percent annual growth rate of dividends for the S&P
     500 during the past five years. However, we need the expected future growth in divi-
     dends, not the past growth rate.
     To the best of our knowledge, there are no free sources that report analysts’ esti-
     mates of the expected future dividend growth rates for the S&P 500. Although we
     can't find the S&P 500's expected dividend growth rate, there are sources that report
     the S&P 500's expected earnings growth rate. For example, Yahoo! reports a 13.03
     percent estimate for the S&P 500's expected annualized earnings growth rate.
     Given these data limitations, there are two practical approaches for estimating
     the forward-looking risk premium. First, you could use the current dividend yield
     and assume that the future growth rate in dividends will be similar to the past
     five-year growth rate in dividends. Using this approach, the required return on the
     market is

0.0109710.97%.

[0.0178(10.0903)]0.0903

rMc

D 0

P 0

(1g)dg

Expected

rate of return

rˆM

D 1

P 0

grRFRPMrM

Required

rate of return

.

TABLE 6-1 Selected Ibbotson Associates Data, 1926–2000

Arithmetic Meana Geometric Meana

Average Rates of Return

Common stocks 13.0% 11.0%

Long-term government bonds 5.7 5.3

Implied Risk Premiums

Common stocks over T-bonds 7.3% 5.7%

aIbbotson Associates calculates average returns in two ways: (1) by taking each of the annual holding period returns

and deriving the arithmetic average of these annual returns and (2) by finding the compound annual rate of return

over the whole period, which amounts to a geometric average.

Go to http://finance.yahoo.
com,enter the ticker sym-
bol for any company, select
“Research” from the pull
down menu, and then click
Get. Included with the other
research on this page are
forecasts of growth rates in
earnings for the next five
years for the company, the
industry, and the sector. Se-
lect “Profile” from the menu
at the top of the page.
Scroll down the resulting
page until you see on the
left side of the page the
heading “More from Mar-
ketGuide,” and then select
“Ratio Comparisons.” This
page provides current val-
ues for the dividend yield of
the company, industry, sec-
tor, and the S&P 500.

The Cost of Capital 229