Since 1900, the world’s equity markets have yielded a total return 120 times higher than the return on short-term government securities, bringing the average ERP to 5.7 percentage points per year.2] If we look at the period from 1970 to 2015, for which we have more complete data, the ERP is even higher. This cannot be explained by company fundamentals such as growth in earnings and dividends in this period, suggesting that market valuation of company profits has changed since 1970. Adjusting for the effect of this re-pricing, the long-term average ERP falls to just below 4 percentage points. Chart: Equity risk premium from different model specifications As we know, past performance is no guarantee of future results. In addition to using historical excess returns, the ERP can also be estimated using more forward-looking models. The most common approach is to estimate the ERP on the basis of current market prices and expected future dividends. We have analysed several different models of this type. On average, these models estimate an expected ERP of just below 6 percentage points. In all the models, the estimate is higher than it was ten years ago. The chart shows that model-based estimates of the ERP are uncertain and can change quickly. The estimates are particularly sensitive to assumptions for dividend growth and the risk-free rate. Growth in firms’ dividends has been particularly strong in the years since the financial crisis.
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