ERP estimation in volatile markets and its implication for investors and financial managers
Equity risk premiums are defined as the excess return that investors require above the risk-free rate for investing in stocks. Equity risk premiums are a major factor not only in investing but also in corporate finance and their estimation has significant consequences for investing, financing and dividend decisions.
Since the financial crisis in 2008, there has been great volatility in the markets and hence in forward-looking equity risk premium (ERP) estimates. Stomas Nicholas and Greg Forsythe (both Deloitte US) found in their new paper, Are You Mispricing the Investment Risk? that most companies rely on static forecasts to estimate equity risk premiums. Such static forecasts do not properly incorporate the volatility of markets and thus often misprice the costs of investment risks. A method which addresses this shortcoming, the implied ERP, uses future cash flow expectations and consequently takes into account current investors’ expectations of risk.
The authors describe the advantages of using the implied ERP approach and further illustrate why investors and managers need to review their ERPs on a regular basis (at least quarterly).
More information on their paper: CFO Insights
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