2.4 Find the equity risk premium (DVM approach)
View the video to see a worked example showing how to find the equity risk premium using the DVM approach.
Transcript
Find the US equity risk premium if this year’s dividend yield for the US stock market is 5 per cent, the expected growth rate of US dividends in the US stock market is 6 per cent, and the US risk-free rate is 4.5 per cent.
Let’s use the Gordon Growth variation of the dividend valuation model which is rearranged to find the expected return, whereby the expected return on a share (E(Ri)) is equal to the expected dividend next year (D1), divided by the current price of the share (Pi) plus the growth rate of dividends (g) from investing in the share.
Use this formula to find the return on the US stock market using the market data given.
Use the dividend yield for the US stock market, which is 5 per cent. It is expected to grow at 6 per cent. So we need to multiply 0.05 by 1.06 and then add the growth rate of 0.06 in order to work out the expected return on the US stock market.
This becomes 0.053 plus 0.06, which gives us 0.113 or 11.3 per cent.
We can now find the equity risk premium. Take the expected return on the market (E(RM)) subtract the risk-free rate (RF) to find the equity risk premium.
The expected return on the market is 11.3 per cent. Subtract the risk-free rate of 4.5 per cent. This gives an expected risk premium of 6.8 per cent.