Sunday, November 28, 2010

Interesting Article on the Equity Risk Premium Used in Textbooks and By Equity Analysts

Dr. David Krause, AIM program director commented, "I just read an interesting article on the equity risk premium used in popular finance textbooks and by practicing stock analysts. It seems like the consensus is to presently use a 5% market risk premium for equity valuation. The AIM students in their stock evaluations utilize discounted cash flow techniques which require the use of a risk premium - they should find this interesting and useful."

Pablo Fernandez, a finance professor at the IESE Business School in Madrid, Spain, recently published several articles that examined the equity premium used in textbooks and by practicing equity analysts. The equity premium (also called market risk premium, equity risk premium, market premium and risk premium), is one of the most important parameters in investment analysis. The term equity premium is used to designate the differential return of the stock market over the risk-free rate (U.S. Treasuries) and is an integral portion of the discount rate used in valuation.

The table below shows that the 5-year moving average used in finance textbooks has declined from 8.4% in 1990 to 5.7% in 2009. Fernandez reported that the average equity premium used by analysts in the U.S. in 2009 was 5.1%.


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