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20 February 2009
US Equity Pulse
How High Is The
Equity Risk Premium?
Binky Chadha
Chief US Equity Strategist
(+1) 212 250-4776
bankim.chadha@db.com
Parag Thatte
Research Analyst
(+1) 212 250-6605
parag.thatte@db.com
Deutsche Bank Securities Inc.
All prices are those current at the end of the previous trading session unless otherwise indicated. Prices are sourced from local
exchanges via Reuters, Bloomberg and other vendors. Data is sourced from Deutsche Bank and subject companies. Deutsche
Bank does and seeks to do business with companies covered in its research reports. Thus, investors should be aware that the firm
may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single
factor in making their investment decision. Independent, third-party research (IR) on certain companies covered by DBSI's research
is available to customers of DBSI in the United States at no cost. Customers can access IR at
http://gm.db.com/IndependentResearch or by calling 1-877-208-6300. DISCLOSURES AND ANALYST CERTIFICATIONS ARE
LOCATED IN APPENDIX 1.
The Equity Risk Discount Rate (ERDR)
7.5%
8.5%
9.5%
10.5%
11.5%
12.5%
13.5%
14.5%
Mar-46
Mar-53
Mar-60
Mar-67
Mar-74
Mar-81
Mar-88
Mar-95
Mar-02
Mar-09
7.5%
8.5%
9.5%
10.5%
11.5%
12.5%
13.5%
14.5%
Recession Equity Risk Discount Rate Average ERDR
The ERDR and Treasury Yields
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
15% Mar-46
Mar-53
Mar-60
Mar-67
Mar-74
Mar-81
Mar-88
Mar-95
Mar-02
Mar-09
2%
3%
4%
5%
6%
7%
8%
9%
10%
11%
12%
13%
14%
Equity Risk Discount Rate 15%
Long term treasury yield
The ERP over Treasuries
-400
-200
0
200
400
600
800
1000
1200
Mar-46
Mar-53
Mar-60
Mar-67
Mar-74
Mar-81
Mar-88
Mar-95
Mar-02
Mar-09
-400
-200
0
200
400
600
800
1000
1200
ERDR premium to Long
Term Treasury yield (bps)
Global Markets Research Company
Equities have sold-off steeply (-52% peak-to-trough, about 2 average postwar
recession declines), raising the question of how high the equity risk
discount rate (ERDR) and premium (ERP) are.
We estimate a long run ERDR of 9.7%.
Academic research identifies the ERP as the excess total return on equities over
some “risk-free” rate over a long period. With historical average price appreciation
of 6.2% and a dividend yield of 3.6%, the total return on US equities was 9.7%
(w/o dividend reinvestment and 10.0%/w). This implies an ERDR of 9.7% and
ERPs of 4.6% over long-term Treasuries and 5.8% over 3m T-bill rates (Figure 1).
Cyclical variations in the ERDR have been the predominant driver of equities.
In that equity prices represent the present value of payouts from earnings, what
have been the relative contributions of changes in the discount rate and earnings
in driving equity prices? Earnings cycles around trend have been relatively longlived,
averaging 3.2 years, with the cumulative earnings loss during down-cycles a
significant -0.5 years of earnings. But this earnings loss is dwarfed by declines in
equity prices during down-cycles, with the price/earnings multiple declining on
average by -6.5. Assuming that investors on average correctly anticipated earnings
down-cycles, earnings declines would have accounted for less than 10% of the
declines in equity prices, while increases in the ERDR for over 90% (Figure 2).
How we measure the ERDR.
We calculate the ERDR as the internal rate of return on realized and forecast future
payouts given market prices. This amounts to assuming that investors’ payout
expectations were historically unbiased estimates of actual outcomes (Figure 3).
How high is the ERDR? And the ERPs?
(i) The ERDR has risen sharply from a low of 8.1% in mid-2007, but at 10% is only
slightly above its historic average of 9.7%. Beginning in 1982, following the Volker
disinflation, the ERDR began to fall, going below its historic average for a
protracted period to reach an all-time low of 7.5% in early 2000 as the tech bubble
peaked. The ERDR always rises around recessions. It rose during the 2000-01
recession then stabilized and has risen again in this recession (Figure 3).
(ii) But the ERDR has risen well above levels suggested by its tight relationships
with fixed-income yields since 1982. Fixed-income yields (short- and long-term
Treasuries and Baa) respectively explain over 80% of the movements in the ERDR
since 1982. ERPs with respect to cash, Treasury or corporate bond yields are
running high, some at levels last seen in the 1970s and 1960s (Figures 4-9).
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