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Strategic Corporate Finance: Applications in Valuation and Capital Structure by Justin Pettit

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MARKET RISK PREMIUM (MRP)

The return premium afforded by stocks over long government bonds (i.e., MRP) is generally believed to be anywhere from 3 to 8 percent. The widely cited Ibbotson and Sinquefeld study (now down from 8 percent, to about 6 to 7 percent) is based on the U.S. arithmetic mean from 1926. It is not that 1926 was an important year in econometric history; this is just when the market tapes started to be archived.

If the study started one year earlier or later, the risk premium would have changed by a full percentage point. Other U.S. studies (employing manual data retrieval) do go back much further (to when the market was largely railroad stocks) and provide estimates closer to the low end of the range.2 Some studies rely on more recent history and this, again, leads to the lower end of the range.

Provided the data represent a “random walk” and there are no discernible trends up or down, more observations will lead to greater predictive accuracy. However, structural economic changes over the past century make the early data less relevant for estimating expected returns today. Macroeconomic factors have conspired such that, in our opinion, a shorter history is more appropriate.

Based on the arithmetic average of annualized monthly return premiums and on forward looking multiples, stock market investors today are likely to expect about a 5 percent premium for bearing the market risk of equities. The risk of holding equities has generally declined; at the same time, ...

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