What's The Best Estimator of The Equity Risk Premium?
I'm teaching advanced corporate finance this semester. As usual, I spend a fairly large chunk of time on the Weighted Average Cost of Capital. One of the issues in the CAPM approach to estimating the cost of equity is what estimate to use for the market risk premium. So of course, I has happy to find a paper by Aswath Damodaran titled "Equity Risk Premiums (ERP): Determinants, Estimation and Implications." Here's the abstract: Equity risk premiums are a central component of every risk and return model in fin ance and are a key input into estimating costs of equity and capital i n both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on s tocks versus bonds over a long time period comprising the expected risk premium. We note the limitat...