Standard Approaches for Estimating Risk Premiums

How do analysts estimate the equity risk premium(s) and default spreads to use when doing valuation? The answer may vary across analysts, but we will focus on the most common approaches used to estimate the two measures.

Equity Risk Premiums

The most widely used approach to estimating equity risk premiums is the historical premium approach. The actual returns earned on stocks over a long time period are estimated and are compared to the actual returns earned on a default-free (usually government) security. The difference, on an annual basis, between the two returns is computed; it represents the historical risk premium. This section takes a closer look at this approach. While users of risk-and-return ...

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