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[sharechat] Equity risk premium

From: "winner69 ." <>
Date: Sat, 29 May 2004 03:53:54 +0000

Dean / Snoopy - some thoughts

One could say that as equities have outperformed bonds over the long term 
then equities are actually less 'risky' than government stock - and that 
there is no need for an equity risk premium. The only counter to this 
argument is that equity investors can actually lose their capital but income 
streams and capital from government stock are generally guaranteed. 
Therefore equities are actually 'riskie'r than government stock and there is 
a need for a equity risk premium to compensate investors for that risk.

You guys have focussed on history for assessing what you think that equity 
risk premium should be today. Using historical data is fraught with problems 
- what periods do you use? what has been the impact of valuation changes in 
the chosen period? what about survivorship bias? etc.

How about assessing an equity risk premium based on a prospective view from 
where the market is currently at. The prospective equity risk premium can be 
expressed as Current Earnings Yield plus Inflation (proxy growth rate) less 
Government Stock Returns (the risk free case). Makes sense as the earnings 
yield plus inflation represents the value of future cash flows from equities 
compared to the risk free rate of government stock.

So in NZ what is the prospective equity risk premium. With an average p/e of 
the top 50 about 18 the earnings yield is 5.5%, inflation expected to be say 
2.5% and with long term government stock returning about 6% the prospective 
equity risk premium is currently about 2%.

This 2% is a little lower than the general figure of 3-4% being seen as an 
appropriate figure. Maybe the NZ market is currently slightly overvalued or 
as Snoopy suggests that the NZ market is a much 'safer' place to be than 
overseas markets.

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