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Estimating the cost of equity
Estimating the cost of equity

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4.1 Identifying the ERP

Complete the activity below to identify the ERP.

Activity 5 Identifying the ERP

Timing: Allow around 15 minutes for this activity

Question 1

1. Identify and evaluate the approach of leading US academic analyst, Professor Aswath Damodaran:

Prior to September 2008, I used 4% as the ERP based on an estimate of the average implied ERP over the period 1960–2007. The banking and financial crisis of 2008 was unlike any other market downturn and exposed weaknesses in developed capital markets. After the crisis, in the first half of 2009, I used an ERP of 5.5% when valuing companies. However, in the later part of 2009, I saw a reversion to historical averages and an ERP of 4.5–5% now seems appropriate for 2010.

(Source: adapted from Daddio, 2010)
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Professor Damodaran uses an implied ERP calculation, based on past evidence (historical averages). This has then been adjusted to take account of the extreme events of 2008 using personal bias.

The expert’s decision to adjust the ERP upwards reflects a view that it will be more difficult to achieve the required gains from stock market investments and thus investing in stock markets carries increased risk.

In 2008, global share prices decreased sharply as investors anticipated a recession, with the knock-on effect for business of lower profits and bankruptcy or liquidation. This information had not been priced in previously.

Note how Damodaran then rejected ‘personal judgement’ and turned back to historical averages again for 2010, although the ERP used stayed higher than the original estimate.

Question 2

2. Why does Damodaran’s approach result in a lower ERP than the implied equity risk premium given by Bloomberg in November 2010 (8.45% for the US)?

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Damodaran is taking a more conservative approach on future growth. His ERP is lower than the Bloomberg results, which take a current, implied approach (taking account of anticipated future growth).

Question 3

3. There are arguments for and against Damodaran’s approach. Try to identify them.

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The arguments revolve around using historical data, which should be representative and accessible, and future predictions of growth, which are ‘best estimates’.

We can see there are difficulties arising from using historical averages (which Damodaran is using) when calculating the ERP as the past does not predict future performance or outcomes.

Also up for debate is the historical time period over which the average should be calculated from. Would a 50-year, ten-year or two-year period be appropriate?

The extreme global market movements of 2008 and 2009 will be incorporated in historical data in future years. In one week in October 2008, the Standard & Poor 500 – the US Stock Exchange index – fell more than 20%.

On the other hand, calculating an implied equity risk premium involves using projected growth rates, which are themselves forecasts.

Point to note…

There are advantages and disadvantages to all approaches.

You can see how the ERP can be adjusted to reflect personal judgement – this is not a bad thing in itself.

After all, there is no point in accepting a number slavishly. But adjustments and how they have been arrived at need to be kept in mind when using the ERP in further calculations and investment appraisal and valuation models.