The CAPM Approach 233Given a current 10-year T-bond rate of around 4.24 percent, the estimated
forward-looking risk premium from this approach is about 10.97 4.24 6.73 per-
cent.
The second approach is to assume the forecasted earnings growth rate will equal
the dividend growth rate.^9 Using this growth estimate, you could estimate the re-
quired return on the market and the forward-looking risk premium as shown above.
In recent years, estimates of the forward-looking risk premium have usually
ranged from 4.5 to 6.5 percent, depending on the date of the estimate and the data
sources used by the analyst.Our View on the Market Risk Premium After reading the previous sections, you
might well be confused about the correct market risk premium, since the different ap-
proachesgivedifferentresults.UsingthehistoricalIbbotsondataoverthelast75years,it
appears that the market risk premium is somewhere between 5.7 and 7.3 percent, de-
pending on whether you use an arithmetic average or a geometric average. However, in
thepast30to40years,thehistoricalpremiumhasbeenintherangeof5to6percent.Us-
ingtheforward-lookingapproach,itappearsthatthemarketriskpremiumissomewhere
in the area of 4.5 to 6.5 percent. To further muddy the waters, the previously cited survey
indicates that 37 percent of responding companies use a market risk premium of 5 to 6
percent, 15 percent use a premium provided by their financial advisors (who typically
make a recommendation of about 7 percent), and 11 percent use a premium in the range
of 4 to 4.5 percent. Moreover, it has been toward the low end of the range when interest
rates were high and toward the high end when rates were low.
Here is our opinion. The risk premium is driven primarily by investors’ attitudes
toward risk, and there are good reasons to believe that investors are less risk averse to-
day than 50 years ago. The advent of pension plans, Social Security, health insurance,
and disability insurance means that people today can take more chances with their in-
vestments, which should make them less risk averse. Also, many households have dual
incomes, which also allow investors to take more chances. Finally, the historical aver-
age return on the market as Ibbotson measures it is probably too high due to a sur-
vivorship bias. Putting it all together, we conclude that the true risk premium in 2002
is almost certainly lower than the long-term historical average of more than 7 percent.
But how much lower is the current premium? In our consulting, we typically use a
risk premium of 5.5 percent, but we would have a hard time arguing with someone
who used a risk premium in the range of 4.5 to 6.5 percent. The bottom line is that
there is no way to prove that a particular risk premium is either right or wrong, al-
though we are extremely doubtful that the premium market is less than 4 percent or
greater than 7 percent.Estimating Beta
Recall from Chapter 3 that beta is usually estimated as the slope coefficient in a regres-
sion, with the company’s stock returns on the y-axis and market returns on the x-axis.
The resultingbetaiscalledthehistoricalbeta,sinceitisbasedonhistoricaldata.Although
thisapproachisconceptuallystraightforward,complicationsquicklyariseinpractice.(^9) In theory, the constant growth rate for sales, earnings, and dividends ought to be equal. However, this has
not been true for past growth rates. For example, the S&P 500 has had past five-year annual average growth
rates of 15.17 percent for sales, 17.49 percent for earnings per share, and 9.03 percent for dividends. Thus,
an analyst must use judgment when using the forecasted growth rate in earnings to estimate the forecasted
growth rate in dividends.
To find an estimate of beta,
go to http://www.
bloomberg. com,enter the
ticker symbol for a stock
quote, and click ”go.”