Chapter 2

The Risk Premium Factor Valuation Model

The Risk Premium Factor (RPF) Model proposes that the equity risk premium (ERP) is a simple function of the risk-free rate. When combined with simplifying assumptions as inputs to the constant growth equation, it explains the observed variation in ERP and changes in price-to-earnings (P/E) ratios and valuations for the Standard & Poor's (S&P) 500 over the past 50 years.

Conventional theory would hold that if the equity risk premium (ERP) were 6.0 percent and 10-year Treasury yield were 4.0 percent, then investors would expect equities to yield 10 percent, but if the 10-year Treasury were 10 percent, then investors would require a 16 percent return—a proportionately smaller premium. I argue that the ERP is not fixed as in the conventional Capital Asset Pricing Model (CAPM) and cannot be determined by looking back or projecting forward, but varies directly with the level of the risk-free rate in accordance with a risk premium factor (RPF). While this proportional RPF is fairly stable, it can and does change over longer periods of time.

To illustrate the concept, with an RPF of 1.48, equities are expected to yield 9.9 percent when Treasury yields are at 4.0 percent and 24.8 percent (10 + 1.48 × 10 = 24.8) when they are at 10 percent to provide investors with the same proportional compensation for risk. In this example, the increase in interest rates (and inflation) caused the risk premium to jump from about 6 percent to 15 percent. ...

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