Deutsche Bank : Discussing the Equity Risk Premium
Jamil Baz, global head of fixed income research at Deutsche Bank, and George Cooper, global fixed income strategist of the same group, are finalizing a client presentation on the danger of overstating the Equity Risk Premium (ERP) when comparing bonds and equities. For this purpose, they evaluate two different approaches used to calculate the ERP.
Identification of the problem
The general idea behind the calculation of the Equity Risk Premium can be divided in 3 steps:
· Estimation of the expected total return on stocks
· Estimation of the expected risk-free return of bond coupons
· Calculating the difference of the above two estimations
Two approaches are proposed for estimating ERP - The first is called the Gordon Growth Model (GGM). It uses a dividend discount model in order to estimate the Equity Risk Premium. The expected total return on stocks (%) is considered equal to the summation of the dividend yield (%) and the expected growth in dividends (%). The second approach is based on the price-to-earnings ratio of the company and its reciprocal, the earnings yield. The expected total return on stocks (%) is estimated to be the earnings yield. However, the two approaches produce highly different results and Jamil Baz is in the tough situation of deciding whether or not he should emphasize one of these approaches during the client meeting or, otherwise, explain the apparent differences between their results.
Model Details and Assumptions
The Gordon Growth Model uses the current average dividend payout ratio of the entire stock market as a starting point to calculate the ERP. However, the current average dividend payout ratio is very arbitrary, and is subject to variations in macro-economic conditions. For example, when nominal interest rate is high, companies will spend less money on new projects based on NPV analysis, and therefore drive up the...