We examined many published analyses and developed a relatively simple methodology that is both stable over time and overcomes the shortcomings of other models. While these views were at the extreme end of the spectrum, it is still easy to get seduced by complex logic and data. Pushed to the extreme, a few analysts even argued that the premium would fall to zero, that the Dow Jones industrial average would reach 36,000 and that stocks would earn the same returns as government bonds. On the other hand, some analysts and academics suggested that the rising stock prices meant that the risk premium was declining. On the one hand, as prices soared ever higher, some investors expected a new era of higher equity returns driven by increased future productivity and economic growth. For example, the run-up in stock prices in the late 1990s prompted two contradictory points of view. This can change the estimated value of a company by more than 40 percent and have profound implications for financial decision making.ĭiscussions about the cost of equity are often intertwined with debates about where the stock market is heading and whether it is over- or undervalued. With expected returns from long-term government bonds currently about 5 percent in the US and UK capital markets, the narrower range implies a cost of equity for the typical company of between 8.5 and 11.0 percent.
Defined as the difference between the cost of equity and the returns investors can expect from supposedly risk-free government bonds.Ĭonflicting approaches to calculating risk have led to varying estimates of the equity risk premium from 0 percent to 8 percent-although most practitioners use a narrower range of 3.5 percent to 6 percent. As central as it is to every decision at the heart of corporate finance, there has never been a consensus on how to estimate the cost of equity and the equity risk premium.
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