Something we need to know
Investors can be fairly confident that over the long haul stocks offer a higher return than bonds. This is to compensate stockholders for the higher risk they take. This higher return is called the equity risk premium (ERP).
It can be calculated historically by looking at the difference in returns realized over various time periods. Or it can be calculated looking forward, coming up with an expected or implied ERP.
The ERP varies quite a bit over time. This can be made clear by a simple historical example. In one year stocks might provide a total return of 15% and ten year treasury bonds 3%. So, in that year the ERP would be 12%. The next year stock might be down 5% and bonds return 3%. The ERP would be a negative 8%. The same variability applies to forward looking implied ERPs.
Why are investors interested in numbers for the ERP? Many investors look at the current implied ERP and ask whether the premium has become too low. If it has, the argument would be that stock prices are too high. Conversely, if the implied ERP is judged to be too high, investors would argue that stock prices are too low and that buying opportunities may be available.
As well, some investors use the relative level of the ERP to make asset allocation decisions.
Aswath Damodaran teaches corporate finance and valuation at the Stern School of Business at New York University. One of his special areas of interest is the ERP and particularly the implied ERP which he describes as a forward-looking and dynamic measure of expected stock returns. Professor Damodaran is also a blogger. He explains one of the reasons he tracks the implied ERP:
“I have long claimed that I am not a market timer, but that is a lie, since every investor times markets, with the difference being in whether the timing is implicit (with cash holdings in your portfolio increasing, when you feel uneasy about markets, and decreasing, when you feel bullish) or explicit (where you actively bet on market direction).”
Musings on Markets – Wednesday, January 19, 2022 Data Update 2 for 2022: US Stocks kept winning in 2021, but…
Institutional investors and professional money managers
Some of the big boys treat the ERP quite seriously. For example, in a 2017 article titled The Equity Risk Premium: A Contextual Literature Review, Laurence B. Siegel, director of research at the CFA Institute Research Foundation, wrote:
“The ERP is widely acknowledged as the most important variable in finance. It is useful
• for determining what returns to expect from each major asset class and from portfolios of securities or asset classes;
• in life-cycle and retirement planning (estimating how much to save and invest in the hope of achieving a given standard of living in retirement); and
• as a component of the opportunity cost of capital or required rate of return in corporate finance.”
In its Jun 21st 2022 edition the Economist magazine had an article titled: How attractively are shares now priced? What a key valuation measure says about buying the dip
The article said: “How attractively are shares now priced? One approach is to use the equity risk premium as a guide. A rough-and-ready version of it suggests that it is not obviously a time for would-be Buffetts to swoop in. Equities are not (yet) priced at fearful levels. An opportunity for greed may yet arise. But the circumstances will be such that only the steeliest of investors can take advantage.” (Emphasis added)
The following chart is from Professor Damodaran. We can see the year end 2021 level of the equity risk premium. It is at 4.24%. This is slightly above the long term averages of 4.21% (1960 – 2021). As he notes on the chart, at 4.24% the premium was earned on top of the risk free rate that was only 1.5%. The long term annual expected return on stocks was therefore 5.75%, well below historic norms.”
On this basis it could be argued that, at that time, since expected returns were well below historic norms, prices were too high. The suggestion would be that prices would have to correct to bring future expected returns back to norms.
None of the uses of ERP mentioned above appear in my approach to investing. I have never needed to come up with a number for the return that can be expected from stocks generally. My investment process operates on the notion that stocks outperform bonds over the long haul and that I will go with that and live within the returns our portfolio throws up.
I never adjust my 100% asset allocation except when I feel the stock market is in a true generalized bubble. The last time I did make an adjustment was in 1998 and I went to bonds for four years. I have been 100% in stocks since the fall of 2002.
There is one way ERP affects my investing. The best approach to assessing the intrinsic value of a stock is a discounted cash flow calculation (DCF). The analysts I base my investment decisions on use this technique to come up with fair values for stocks I’m interested in.
Central to any DCF is a discount rate. Analysts come up with a discount rate in a subjective fashion based on their experience and judgement. There are three components, a risk free rated, an equity risk premium (ERP) and company specific adjustment.
For most DCF calculations the risk free rate is the ten year Treasury bond rate. We know that this rate varies. It is set through market dynamics in the bond market. The outlook for inflation is a significant factor. The outlook for the economy also impacts Treasury bond rates. So, the risk free rate is a moving part.
The expected or implied ERP component of the discount rate is also a moving part.
The company specific adjustment for the discount rate is subjective and also a moving part.
DCF calculation also includes expectations for earnings and future cash flow projections which depend on predictions about the future. This is another moving part.
Need for margin of safety
There are a lot of subjective components. Even so, the analysts typically come up with a single number in their estimate of fair value. The single number often gives the impression of accuracy. In reality, the estimate is only vaguely right. That is why a margin of safety is needed in any stock purchase.
The Equity Risk Premium pops up from time to time in investors’ reading. It behoves us to understand what it means, whether it is telling us anything and how it affects us. In this post I have simply noted that I don’t make any investment decisions based on the ERP. It does affect my investing in that it is an intrinsic part of discounted cash flow techniques for estimating the fair value of stocks.
To read more about the Equity Risk Premium you might check out these posts:
To read more about Discounted Cash Flow techniques for valuing stocks take a look at:
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