Unlocking Exponential Growth: Transform Your Financial Future Today

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 equity risk premium and it’s what you can expect from the overall stock market above a 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 portfolio return expectations and determine asset allocation. A higher premium implies that you would invest a greater share of your portfolio into stocks.

The capital asset pricing model also relates a stock’s 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 expect better returns from stocks compared to bonds due to the three primary risks:

1. Dividends can fluctuate, unlike predictable bond coupon payments.
2. Bondholders have a prior claim while holders of common stock have a residual claim when it comes to corporate earnings.
3. Stock returns tend to be more volatile although this is less true when the 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 stock market to give us going forward?

Getting at the Premium

These are the four ways to estimate the future equity 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 Professor William Goetzmann of Yale has cautioned, “History, after all, is a series of accidents; the existence of the time series since 1926 might itself be an accident.”

One widely accepted historical accident concerns the abnormally low long-term returns to 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 monetary policy and didn’t anticipate inflation.

Building a Supply-Side Model

The most popular approach 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 market timing. It’s understood that markets will be overvalued or undervalued in the 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 income tax rate of 35%. Equities may be deferred entirely into a capital gains rate of 15% (no dividends). The after-tax picture makes equities look even better in this case.

Step One: Estimate the Expected Total Return on Stocks

Dividend-based Approach

The two leading supply-side approaches start with either dividends 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% 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 insist 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 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 additional 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 Gordon Growth Model that says that the fair price of a stock (P) is a function of the dividend per share (D), growth in the dividend (g) and the required or expected rate of return (k).

Earnings-based Approach

Another approach looks at the price-to-earnings (P/E) ratio and its reciprocal, the 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 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 retained earnings they often opt to reinvest result in only subpar returns as companies grow. The retained earnings should have instead been distributed as 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 future.

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 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 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 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 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 risk-free rate of return and step three is to try to arrive at a reasonable equity risk premium.