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The Implied Equity Risk Premium - An Evaluation of Empirical Methods

The Implied Equity Risk Premium - An Evaluation of Empirical Methods
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Year:    2007

Author:    Schröder, David

Credit and Capital Markets – Kredit und Kapital, Vol. 40 (2007), Iss. 4 : pp. 583–613

Abstract

A new approach of estimating a forward-looking equity risk premium (ERP) is to calculate an implied risk premium using present value (PV) formulas. This paper compares implied risk premia obtained from different PV models and evaluates them by analyzing their underlying firm-specific cost-of-capital estimates. It is shown that specific versions of dividend discount models (DDM) and residual income models (RIM) lead to similar ERP estimates. However, cross-sectional regression tests of individual firm risk suggest that there are qualitative differences between both approaches. Expected firm risk obtained from the DDM is more in line with standard asset pricing models and performs better in predicting future stock returns than estimates from the RIM. (JEL G12)

Journal Article Details

Publisher Name:    Global Science Press

Language:    Multiple languages

DOI:    https://doi.org/10.3790/ccm.40.4.583

Credit and Capital Markets – Kredit und Kapital, Vol. 40 (2007), Iss. 4 : pp. 583–613

Published online:    2007-10

AMS Subject Headings:    Duncker & Humblot

Copyright:    COPYRIGHT: © Global Science Press

Pages:    31

Author Details

Schröder, David

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Section Title Page Action Price
David Schröder: The Implied Equity Risk Premium - An Evaluation of Empirical Methods 583
I. Introduction 583
II. The Calculation of the Cost of Capital 585
1. The Implied Cost of Capital 585
2. Employed Models 586
3. Assessment of the Models 588
4. Empirical Implementation 589
III. Data Description 590
1. Data for the Cost of Capital Calculation 590
2. Data for Regression Tests 592
a) Betas 592
b) Volatility 593
c) Firm Characteristics 593
3. Data for Return Forecast Regressions 594
IV. The Implied Equity Risk Premium 594
V. Analysis of Company-specific Implied Cost of Capital Estimates 596
1. Cross-Sectional Regression Tests 596
a) The Regression Setup 596
b) Individual Firm Regressions with Firm Betas 598
c) Individual Firm Regressions with Country Betas 599
2. Return Prediction 600
VI. Conclusion 601
References 602
Appendix 604
Summary 613
Zusammenfassung 613