Stocks should provide a greater return than safer investments like Treasury bonds, at least in theory. The difference in return is referred to as the 澳洲幸运5开奖号码历史查询:equity risk premium and it's what you can expect from the overall stock market above a 澳洲幸运5开奖号码历史查询:risk-free return in bonds.

There's a vigorous debate among experts about the methods used to calculate the equity premium and the resulting answers.

Why Does the Equity Risk Premium Matter?

The equity risk premium helps to set 澳洲幸运5开奖号码历史查询:portfolio return expectations and determine 澳洲幸运5开奖号码历史查询:asset allocation. A higher premium im﷽plies that you would invest a gre𝄹ater share of your portfolio into stocks.

The capital asset pricing model also relates a stock's 澳洲幸运5开奖号码历史查询:expected return to the equity premium. A stock that's riskier than the broader market as measured by its beta should offer returns that are even higher 🦹than the equity premium.

Greater Expectations

We eওxpect better retur🔜ns from stocks compared to bonds due to the three primary risks:

1. 澳洲幸运5开奖号码历史查询:Dividends can fluctuate, unlike predictable bond coupon payments.
2. Bondholders have a prior claim while holders of 澳洲幸运5开奖号码历史查询:common stock have a residual claim when it comes to 澳洲幸运5开奖号码历史查询:corporate earnings.
3. Stock returns tend to be more volatile although this is less true when the 澳洲幸运5开奖号码历史查询:holding period is longer.

History validates the theory. U.S. stocks have outperformed Treasuries over any such interval in the past 200-plus years if you're willing to consider holding periods of at least 10 or 15 years.

History is one thing but what we really want to know is tomorrow's equity premium. How much extra return should we expect the 澳洲幸运5开奖号码历史查询:stock market to give us going forward?

Getting at the Premium

These are the four ways t🦩o estimate the future equi🍃ty risk premium.

Opinion surveys naturally produce optimistic estimates as do extrapolations of market returns but extrapolation is a dangerous business. It depends on the time horizon selected and we can't know that history will repeat itself. As has cautioned, "History, after all, is a series of accidents; the existence of the 澳洲幸运5开奖号码历史查询:time series since 1926 might itself be an accident."

One widely accepted historical accident concerns the abnormally low long-term returns to 澳洲幸运5开奖号码历史查询:bondholders that started right after World War II. Low bond returns subsequently increased the observed equity premium. Bond returns were low in part because bond buyers in the 1940s and 1950s misunderstood government 澳洲幸运5开奖号码历史查询:monetary policy and didn't anticipate 澳洲幸运5开奖号码历史查询:inflation.

Building a Supply-Side Model

The most popular approaꩲch is to build a supply-side model. It has three steps:

1. Estimate the expected total return on stocks.
2. Estimate the expected risk-free return on bonds.
3. Find the difference: expected return on stocks minus risk-free return equals the equity risk premium.

We're looking at expected returns that are long-term, real, compound, and pre-tax. "Long-term" means somewhere in the neighborhood of 10 years. Short horizons raise questions about 澳洲幸运5开奖号码历史查询:market timing. It's understood that markets will be overvalued or undervalued in the 澳洲幸运5开奖号码历史查询:short run.

"Real" means net of inflation. "Compound" means we ignore the ancient question of whether forecasted returns ought to be calculated as arithmetic or geometric, time-weighted averages.

Taxes Make a Difference

It's convenient to refer to pre-tax returns but individual investors should care about after-tax returns. Taxes make a difference.

Let's say the risk-free rate is 3% and the expected equity premium is 4%. We therefore expect equity returns of 7%. Now say we earn the risk-free rate entirely in bond coupons taxed at an 澳洲幸运5开奖号码历史查询:income tax rate of 35%. Equities may be deferred entirely into a 澳洲幸运5开奖号码历史查询:capital gains rate of 15% (no dividend🍸s). The after-tax picture makes equities look even better in this case.

Step One: Estimate t🔯he Expected ♏Total Return on Stocks

Dividend-based Approach

The two leading supply-side approaches start with either div🦹idends or 🌳earnings.

The dividend-based approach says that returns are a function of dividends and their future growth. Consider an example with a single stock that's priced at $100 today and pays a constant 3% 澳洲幸运5开奖号码历史查询:dividend yield calculated as ꧟dividend per share divided by stock🧸 price but for which we also expect the dividend in dollar terms to grow at 5% per year.

You can see that the stock price must go up 5% per year, too, if we grow the dividend at 5% per year and ins💫ist on a constant 🌸dividend yield. The key assumption is that the stock price is fixed as a multiple of the dividend.

It's equivalent in terms of 澳洲幸运5开奖号码历史查询:P/E ratios to assuming that 5% earnings growth and a fixed P/E multiple must push the stock price up 5% per year. Our 3% dividend yield naturally gives us a 3% return at the end of five years or $19.14 if the dividends are reinvested. The growth in dividends has pushed the stock price to $127.63 which gives us an 🌊additionಌal 5% return. We get a total return of 8%.

That's the idea behind the dividend-based approach: The dividend yield plus the expected growth in dividends equals the expected total return. It's a re-working of the 澳洲幸运5开奖号码历史查询:Gordon Growth Model that says that the fair price of a stock (P) is a function of the 澳洲幸运5开奖号码历史查询:dividend per share (D), growth in the dividend (g) and the required or expected 澳洲幸运5开奖号码历史查询:rate of return (k).

Earnings-based Approach

Another approach looks at the price-to-earnings (P/E) ratio and its reciprocal, the 澳洲幸运5开奖号码历史查询:earnings yield which is earnings per share divided by stock price. The idea is that the market's expected long-run real return is equal to the current earnings yield. This theory says that the expected return is equal to the earnings yield of 4% (1 ÷ 25 = 4%) if the P/E ratio for the 澳洲幸运5开奖号码历史查询:S&P 500 was almost 25 at the end of the year. If that seems low, 🌺remember it's a real return. Add a rate of inflation to get a nominal return.

Here's the math that gets you the earnings-based approach.

The dividend-based approach explicitly adds a growth factor but growth is implicit in the earnings model. It assumes that the P/E multiple already impounds future growth. The model assumes the earnings are profitably reinvested at 4% if a company has a 4% earnings yield but doesn't pay dividends.

Even experts disagree. Some "rev up" the earnings model on the idea that companies can use high-priced equity to make progressively more profitable investments at higher P/E multiples. Others prefer the dividend approach for the opposite reason. They show that the 澳洲幸运5开奖号码历史查询:retained earnings they often opt to reinvest result in only s𒊎ubpar returns as companies grow. The retained earnings should have instead been distributed ไas dividends.

Handle With Care

The equity premium refers to a long-term estimate for the entire market of publicly traded stocks. Several studies have cautioned that we should expect a fairly conservative premium in the futu⛦re.

Academic studies are almost certain to produce low equity risk premiums for two reasons regardless of when they're conducted. They assume that the market is correctly valued. The dividend yield and the earnings yield have reciprocal 澳洲幸运5开奖号码历史查询:valuation multiples in both the dividend-based approach🗹 and the earnings-based approach.

Both models assume that the valuation multiples of the price-to-dividend and P/E ratios are correct in the present and won't change going forward. It's notoriously difficult to predict an expansion or contraction of the market's valuation multiple.

The earnings model might forecast 4% based on a P/E ratio of 25 and earnings may grow at 4% but if the P/E multiple expands to 30 in the next year then the total market return will be 25%. Multiple expansion alone contributes 20% (30/25 -1 = +20%).

The second reason low equity premiums tend to characterize academic estimates is that the total market growth is limited over the long term. You'll recall that we have a 澳洲幸运5开奖号码历史查询:factor for dividend growth in the♚ dividend-based approach. Academic studies assume that dividend growth for the overall market can't exceed the total economy's growth over the long term.

If the economy measured by 澳洲幸运5开奖号码历史查询:gross domestic product (GDP) or national income grows at 4% then studies assume that markets can't collectively outpace this growth rate. A real equity premium of 4% or 5% is pretty much impossible to exceed if you begin with an assumption that the market's current valuation is approximately correct and set the economy's growth as a limit on long-term dividend growth or earnings or 澳洲幸运5开奖号码历史查询:earnings per share growth.

The Bottom Line

Now that we've explored the risk premium models and their challenges, it's time to look at them with actual data. The first step is to find a reasonable range of expected equity returns. Step two is to deduct a 澳洲幸运5开奖号码历史查询:risk-free rate of return and step three is to try💫 to arrive at a reasonable equity risk premiu💙m.