0 Equity premium

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Pablo Fernández IESE Business School

Equity Premium: Historical, Expected, Required and Implied

Equity Premium: Historical, Expected, Required and Implied
Pablo Fernández* PricewaterhouseCoopers Professor of Corporate Finance IESE Business School Camino del Cerro del Aguila 3. 28023 Madrid, Spain Telephone 34-91-357 08 09. e-mail: fernandezpa@iese.edu

ABSTRACT The equity premium designates four different concepts: Historical Equity Premium (HEP); Expected Equity Premium (EEP); Required Equity Premium (REP); and Implied Equity Premium (IEP). We highlight the confusing message in the literature regarding the equity premium and its evolution. The confusion arises from not distinguishing among the four concepts and from not recognizing that although the HEP is equal for all investors, the REP, the EEP and the IEP differ for different investors. A unique IEP requires assuming homogeneous expectations for the expected growth (g), but we show that there are several pairs (IEP, g) that satisfy current prices. We claim that different investors have different REPs and that it is impossible to determine the REP for the market as a whole, because it does not exist. We also investigate the relationship between (IEP – g) and the risk free rate. There is a kind of schizophrenic approach to valuation: while all authors admit different expectations of equity cash flows, most authors look for a unique discount rate. It seems as if the expectations of equity cash flows are formed in a democratic regime, while the discount rate is determined in a dictatorship.

JEL Classification: G12, G31, M21 Keywords: equity premium; equity premium puzzle; required market risk premium; historical market risk premium; expected market risk premium; risk premium; market risk premium; market premium.

February 16, 2007

*

I would like to thank, without implicating, Michael Brennan, Jose Manuel Campa, George Constantinides, Javier Estrada, Christophe Faugere, Roger Ibbotson, Juan

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