Cost of Capital: Applications and Examples, + Website, 5th Edition

APPENDIX 8B

Other Sources of ERP Estimates

The following is a list of published opinions and guidelines on the ERP. These are not the only sources, but represent a cross section of opinion on the subject. These ERP estimates are not necessarily converted to an arithmetic average over a 20-year bond, nor do they all indicate what base the ERP is added to.

Principles of Corporate Finance, 11th ed., takes no official position on the exact ERP. But the authors believe that a range of 5% to 8% premium over T-bills is reasonable for the United States (equivalent to a premium over long-term government bonds of approximately 3.5% to 6.5%). They warn that “out of this debate only one firm conclusion emerges: Do not trust anyone who claims to know what returns investors expect.”¹

Valuation: Measuring and Managing the Value of Companies, 5th ed., note that “Different forms of measurement converge on an appropriate range of market risk premium of 4.5% to 5.5%, which was held even during the financial crisis of 2008.”² The authors use a forward-looking model to estimate real expected market returns for 1962 through 2008 averaging 7.0%. Subtracting the real return on TIPS of 1.6, they estimate the risk premium of 5.4%.

The authors conclude on their assessment of the research and evidence:

Although many in the finance profession disagree about how to measure the market risk premium (ERP), we believe 4.5 to 5.5% is the appropriate range. Historical estimates found in most textbooks (and locked ...