Valuation, 7th Edition

Appendix FTechnical Issues in Estimating the Market Risk Premium

In its simplest form, the historical market risk premium can be measured by subtracting the return on government bonds from the return (total return to shareholders) on a large sample of companies over some time frame. But this requires many choices that will affect the results. For the best measurement of the risk premium using historical data, follow the guidelines presented in this appendix.

Calculate Premium Relative to Long-Term Government Bonds

When calculating the market risk premium, compare historical market returns with the return on ten-year government bonds. Long-term government bonds match the duration of a company’s cash flows better than short-term bonds.

Use the Longest Period Possible

How far back should you look when using historical observations to predict future results? If the market risk premium is stable, a longer history will reduce estimation error. Alternatively, if the premium changes and estimation error is small, a shorter period is better. To determine the appropriate historical period, consider any trends in the market risk premium compared with the imprecision associated with short-term estimates.

To test for the presence of a long-term trend, we regress the U.S. market risk premium against time. Over the past 119 years, no statistically significant trend is observable.¹ Based on regression results, the average excess return has fallen by two basis points a year, but this result ...