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The Implied Equity Risk Premium: An Evaluation of Empirical Methods

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  • Schröder, David

Abstract

A new approach of estimating a forward-looking equity risk premium (ERP) is to calculate the implied risk premium using present value (PV) formulas. This paper compares implied risk premia obtained from dierent PV models and evaluates them by analyzing their underlying firmspecific 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, the results of cross-sectional regression tests of individual firm risk suggest that there are qualitative dierences 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.

Suggested Citation

  • Schröder, David, 2005. "The Implied Equity Risk Premium: An Evaluation of Empirical Methods," Bonn Econ Discussion Papers 13/2005, University of Bonn, Bonn Graduate School of Economics (BGSE).
    • Handle: RePEc:zbw:bonedp:132005
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    More about this item

    Keywords

    equity risk premium; cost of capital; expected stock returns;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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