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Real growth + Dividend yield + Inflation - Risk-free rate.

The equity risk premium (ERP) can be thought of as both expected (ex ante) and achieved (ex post). The ex-ante ERP is not directly observable—it needs to be derived by making assumptions, in particular about investors’ expectations regarding future dividend growth.

There are a number of different approaches to estimating the ERP.

The three most common are:

  1. Calculating the ex-post ERP based on historical equity and bond returns.
  2. Estimating the ex-ante ERP using a one-stage dividend discount model, with a fixed growth assumption for future dividends.
  3. A more complex multi-stage dividend discount model, as embodied in GS DDM, that allows variation in earnings growth and pay-out ratios.

An excessively high risk premium suggests that the market is sceptical of one of the following: the current level of interest rates, the outlook for inflation or the outlook for earnings.

See Damodaran on ERP.

Last Updated:28-Sep-12
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