As central as it is to every decision at the heart of corporate finance, there has never been a consensus on how to estimate the cost of equity and the equity risk premium.1
Conflicting approaches to calculating risk have led to varying estimates of the equity risk premium from 0 percent to 8 percent—although most practitioners use a narrower range of 3.5 percent to 6 percent. With expected returns from long-term government bonds currently about 5 percent in the US and UK capital markets, the narrower range implies a cost of equity for the typical company of between 8.5 and 11.0 percent. This can change the estimated value of a company by more than 40 percent and have profound implications for financial decision making.
Discussions about the cost of equity are often intertwined with debates about where the stock market is heading and whether it is over- or undervalued. For example, the run-up in stock prices in the late 1990s prompted two contradictory points of view. On the one hand, as prices soared ever higher, some investors expected a new era of higher equity returns driven by increased future productivity and economic growth. On the other hand, some analysts and academics suggested that the rising stock prices meant that the risk premium was declining. Pushed to the extreme, a few analysts even argued that the premium would fall to zero, that the Dow Jones industrial average would reach 36,000 and that stocks would earn the same returns as government bonds. While these views were at the extreme end of the spectrum, it is still easy to get seduced by complex logic and data.
We examined many published analyses and developed a relatively simple methodology that is both stable over time and overcomes the shortcomings of other models. We estimate that the real, inflation-adjusted cost of equity has been remarkably stable at about 7 percent in the US and 6 percent in the UK since the 1960s. Given current, real long-term bond yields of 3 percent in the US and 2.5 percent in the UK, the implied equity risk premium is around 3.5 percent to 4 percent for both markets.
There are two broad approaches to estimating the cost of equity and market risk premium. The first is historical, based on what equity investors have earned in the past. The second is forward-looking, based on projections implied by current stock prices relative to earnings, cash flows, and expected future growth.
The latter is conceptually preferable. After all, the cost of equity should reflect the return expected (required) by investors. But forward-looking estimates are fraught with problems, the most intractable of which is the difficulty of estimating future dividends or earnings growth. Some theorists have attempted to meet that challenge by surveying equity analysts, but since we know that analyst projections almost always overstate the long-term growth of earnings or dividends,2 analyst objectivity is hardly beyond question. Others have built elaborate models of forward-looking returns, but such models are typically so complex that it is hard to draw conclusions or generate anything but highly unstable results. Depending on the modeling assumptions, recently published research suggests market risk premiums between 0 and 4 percent.3
Unfortunately, the historical approach is just as tricky because of the subjectivity of its assumptions. For example, over what time period should returns be measured—the previous 5, 10, 20, or 80 years or more? Should average returns be reported as arithmetic or geometric means? How frequently should average returns be sampled? Depending on the answers, the market risk premium based on historical returns can be estimated to be as high as 8 percent.4 It is clear that both historical and forward-looking approaches, as practiced, have been inconclusive.
Overcoming the typical failings of economic models
In modeling the behavior of the stock market over the last 40 years,5 we observed that many real economic variables were surprisingly stable over time (including long-term growth in corporate profits and returns on capital) and that much of the variability in stock prices related to interest rates and inflation (Exhibit 1). Building on these findings, we developed a simple, objective, forward-looking model that, when applied retrospectively to the cost of equity over the past 40 years, yielded surprisingly stable estimates.
US media P/E vs. inflation
Forward-looking models typically link current stock prices to expected cash flows by discounting the cash flows at the cost of equity. The implied cost of equity thus becomes a function of known current share values and estimated future cash flows (see sidebar, “Estimating the cost of equity”). Using this standard model as the starting point, we then added three unique characteristics that we believe overcome the shortcomings of many other approaches:
1. Median stock price valuation. For the US, we used the value of the median company in the S&P 500 measured by P/E ratio as an estimate of the market’s overall valuation at any point in time. Most researchers have used the S&P 500 itself, but we argue that the S&P 500 is a value-weighted index that has been distorted at times by a few highly valued companies, and therefore does not properly reflect the market value of typical companies in the US economy. During the 1990s, the median and aggregate P/E levels diverged sharply. Indeed by the end of 1999, nearly 70 percent of the companies in the S&P 500 had P/E ratios below that of the index as a whole. By using the median P/E ratio, we believe we generate estimates that are more representative for the economy as a whole. Since UK indices have not been similarly distorted, our estimates for the UK market are based instead on aggregate UK market P/E levels.
2. Dividendable cash flows. Most models use the current level of dividends as a starting point for projecting cash flows to equity. However, many corporations have moved from paying cash dividends to buying back shares and finding other ways to return cash to shareholders, so estimates based on ordinary dividends will miss a substantial portion of what is paid out. We avoid this by discounting not the dividends paid but the cash flows available to shareholders after new investments have been funded. These are what we term “dividendable” cash flows to investors that might be paid out through share repurchases as ordinary dividends, or temporarily held as cash at the corporate level.
We estimate dividendable cash flows by subtracting the investment required to sustain the long-term growth rate from current year profits. This investment can be shown to equal the projected long-term profit growth (see sidebar, “Estimating the cost of equity”) divided by the expected return on book equity. To estimate the return on equity (ROE), we were able to take advantage of the fact that US and UK companies have had fairly stable returns over time. As Exhibit 2 shows, the ROE for both US and UK companies has been consistently about 13 percent per year,6 the only significant exception being found in UK returns of the late 1970s.
Return of book equity (ROE)
3. Real earnings growth based on long-term trends. The expected growth rate in cash flow and earnings was estimated as the sum of long-term real GDP growth plus expected inflation. Corporate profits have remained a relatively consistent 5.5 percent of US GDP over the past 50 years. Thus, GDP growth rates are a good proxy for long-term corporate profit growth. Real GDP growth has averaged about 3.5 percent per year over the last 80 years for the US and about 2.5 percent over the past 35 years for the UK. Using GDP growth as a proxy for expected earnings growth allows us to avoid using analysts’ expected growth rates.
We estimated the expected inflation rate in each year as the average inflation rate experienced over the previous five years.7 The nominal growth rates used in the model for each year were the real GDP growth combined with the contemporary level of expected inflation for that year.
We used the above model to estimate the inflation-adjusted cost of equity implied by stock market valuations each year from 1963 to 2001 in the US and from 1965 to 2001 for the UK (Exhibit 3). In the US, it consistently remains between 6 and 8 percent with an average of 7 percent. For the UK market, the inflation-adjusted cost of equity has been, with two exceptions, between 4 percent and 7 percent and on average 6 percent.
Annual estimates of the real cost of equity
The stability of the implied inflation-adjusted cost of equity is striking. Despite a handful of recessions and financial crises over the past 40 years including most recently the dot.com bubble, equity investors have continued to demand about the same cost of equity in inflation-adjusted terms. Of course, there are deviations from the long-term averages but they aren’t very large and they don’t last very long. We interpret this to mean that stock markets ultimately understand that despite ups and downs in the broad economy, corporate earnings and economic growth eventually revert to their long-term trend.
We also dissected the inflation-adjusted cost of equity over time into two components: the inflation-adjusted return on government bonds and the market risk premium. As Exhibit 4 demonstrates, from 1962 to 1979 the expected inflation-adjusted return on government bonds appears to have fluctuated around 2 percent in the US and around 1.5 percent in the UK. The implied equity risk premium was about 5 percent in both markets.8 But in the 1990s, it appears that the inflation-adjusted return on both US and UK government bonds may have risen to 3 percent, with the implied equity risk premium falling to 3 percent and 3.6 percent in the UK and US respectively.
Decomposition of the inflation-adjusted cost of equity
We attribute this decline not to equities becoming less risky (the inflation-adjusted cost of equity has not changed) but to investors demanding higher returns in real terms on government bonds after the inflation shocks of the late 1970s and early 1980s. We believe that using an equity risk premium of 3.5 to 4 percent in the current environment better reflects the true long-term opportunity cost for equity capital and hence will yield more accurate valuations for companies.