Session 4: Equity Risk Premiums

[@ayushsultania1980]

WATCHING THIS IN 2024, I MUST SAY YOU ARE A GEM IN THE FIELD OF FINANCE.......KEEP UP THE GOOD WORK

[@ziqiyang3917]

This video solves all my confusions and I strongly suggest anyone who is as noob as me to finance and still feels puzzled when watching the video, pause and rewatch, you will get it eventually, trust me.

[@budhadityadebnath3706]

I am currently pursuing my CFA Level 2 and FRM Part 1, referring to Professor Damodaran's videos literally opens my mind into new ways of thinking. Thank You so much for your videos!!!

[@RezaArdhiansyah]

how do youprusing two things at once, are the materials between CFA and FRM similar?

[@budhadityadebnath3706]

@@RezaArdhiansyah Not really, but there are similarities between the two

[@anandtiwari7869]

@@budhadityadebnath3706 I hope you got both the charters by now :)

[@nickmhc]

I didn’t realize this guy was publicly traded under GLDM and BAR - he’s *gold*

[@marsaetos9610]

Haha his videos are too

[@nathansturgess6809]

No wonder my lecturer loves you.. ! Thanks! Really clear and concise.

[@Paltibenlaish]

Thanks for sharing but in my humble opinion I think it would be better if you show us how we can apply this theory in some real cases, where you enter to excel and extract real and updated data. thanks

[@andrezaghi9345]

Aswath, thank you for share with us your knowledge and insights. You just gained a big fan in Sao Paulo, Brazil. Hugs, my friend !!

[@ClaudioPascual]

it took me a few visualizations but finally i got it all. thank u for your work!

[@shaileshtripathy8611]

Forward looking risk premiums, an idea quite simple, yet so revolutionary!

[@MrBish435]

Can you explain to me how he got the cashflows? the PV = 1426.19 that is the S&P500 market return for that day. Where did the cashflows from ?

[@rahulp4943]

@@MrBish435 69.46 is the yield from the markets in 2012 based on the average of last 5 decades...analysts expect(assumption taken) the yield growth in markets @5.27% cagr ..those expected yeids from the market are cash flows here..

[@MrBish435]

@@rahulp4943 thank you soooooo much!!

[@rushilkulkarni8671]

If we use a historical growth rate r, to find the future cashflows, instead of the one projected by analysts, does the forward looking premium lose its essence and became back ward looking? Also where do I find the analyst projected numbers?

[@rodrigocacioli3596]

Valuation is more about the narrative, we will never get into a consensus. For example: the best risk premium for me, in Brazil, is the expected return of the market + global risk + country (Brazil risk) + company risk. I have a macro view for all these topics regarding the next years, so I'll keep on adding risk premiums according to my personal view for each one of the topics. No regressions or crazy numbers. My risk premium is more like a "feeling number" that I feel comfortable regarding my opinion of the US market, brazilian market and the company itself. It's usually a higher rate, more conservative, which also gives me a more conservative number regarding the valuation of the company. Your valuation doesn't have to be spot on, just work with different scenarios and find a conservative range of fair prices.

[@BhromonBhomra]

But aren't you already factoring in those risks in the risk free return?

[@schulbz]

@@BhromonBhomra These should reflect in the market risk (systematic risk).

[@pramitmehta258]

Thank you so much professor. Your lectures are really helpful.

[@batatambor]

Finally you haven't said which one of the three approaches to compute the Cost of Equity is the best. Should we use CRP outside the beta, inside the beta or with lambda? Does anyone knows more about when to use each approach???

[@daanishdan318]

This is based on my understanding. Hope it helps :) TBH, I am still trying to understand how beta works. Approach 1: Easiest approach - Use for lemonade stands / Car washes etc. Simple companies businesses Approach 2: Simple supply-chains - Use for Companies "produce" in only one country but supply to different countries. Like Minerals - iron mines etc (assuming no geo-politics) Approach 3: Complex supply chains - there are bottlenecks (major) in the supply chain. Think TSMC (semi-conductors), rare earth metals etc. This kind of analysis can be much much harder/subjective.

[@av5957]

Where is the best place to get the data for buy backs and dividends on the S&P ?

[@dennis6325]

Excellent. You have managed to precisely calculate the ERP using a WAG of the growth rate.

[@TTTT-sj3vz]

where can I find 5 years of analyst estimate of the sp500 ???

[@Rahul_MonkvestorRA]

Sir, could please share the link to the equity risk premiums updated by you each year ? thank you so much for this wonderful, in-depth content

[@Dylan-cr5ub]

Thank you Aswath for this educative video ❤.

[@thomaswalker9516]

Thanks so glad I found you!

[@BlueIceAce2015]

Very interesting take. Thank you!

[@justjackass95]

Great contents. Thank you.

[@FranzJosephGC]

Isn't the implied ERP flawed though in that it assumes a stable, growing economy and ignores the risk of recession? Whereas if you turn to historic data, you will be factoring in recession. Thus, using the implied ERP you might end up overestimating the market's performance.

[@andresrubio2292]

The risk of recession is captured in the current value of the index. Hope this helps!

[@nathansturgess6809]

For anyone else who might be confused. There is a typo on the slide on 11:02. The bottom line should end like: "5.8% + (1.75% * 1.5) = 8.43%"

[@nicholasdriscoll2583]

21/14 is 1.5

[@fundip43]

This may be to simplistic or less globally orientated But when analyzing risk free investments would a inflationary environment incentivize risk as it would decrease risk free net return and relatively lower the bar for risky or equity investments premiums

[@justagoose5528]

How can i find the information about actual cash returned to stockholders for s&p 500?

[@daiweitang4152]

I believe there was a typo in the central box at the slide of 7:22; the last term looks clearly wrong to me bc if r=0.0176, then the (r-0.0176) in denominator would then become zero. Based on my understanding of what Dr. Damodaran was trying to express: the last term should be 1426.19*(1+0.0527)^5/(1+0.0176)^5, which is the present value of stock price assuming the index grows 5.25% for the five years. How does everyone else think? Correct me if I'm wrong

[@VinodTilwani1994]

R is not equal to 1.76%

[@AnonymousThinker-op3vr]

r is the rate youre trying to find, the rate at which your cost equals the expected cash flows from the investment. and 1.76% (Rf) is reduced from r (which is your market return Rm) so that the remainder is the risk premium you intend on finding (Rm-Rf)

[@touchmate123456]

Really helpful and easy to understand

[@parthagarwal2015]

Thank you sir for the knowledge

[@impartialx7182]

Can someone clarify why the "r" variable in perpetuity changes to 0.078885 and for the first 5 years = 0.052692? (calculated by dividing 73.12 by 69.46 minus 1)

[@fjdsklfajl]

Feel free to correct me if I'm wrong but from my understanding it was to do with the reverting to 10yr maturity rate, so you add 0.0176.

[@SFW7]

Hi Prof, I have a few questions about the ERP calculation from @8:45: You mentioned that we grow last year's payout (72.25) but the calculation is done for the 10 year average of 69.46. Which one should we use? (In your Corporate Finance course, we use last 12 month figures instead of 10-year average) Second, you also mentioned that we can simply add dividends and buyback of all US companies for that year. Could please share how that can be done in practice as there are so many listed companies? As in, is there a database that gives you those figures? Many, many thanks and respects.

[@money66666]

Thank you for these videos, they are really invaluable. Can anyone fill me in on how average total yield was calculated of 69.46 even though last year returns was 72.25 at 8:32

[@roarkgan]

+Friendly Spiderman : He has used the last 10 years average dividend to project future dividends. That is 69.46. 72.25 is just the dividend in one of the years i.e. 2012

[@MrDfinance]

+Ganesh V How was the average dividend calculated? Is it a simple average of the cumulative dividends paid out by all companies within the S&P 500? If it is an average, why is it being mentioned as the yield for 10 years?

[@oompaloompa3730]

I'm sure that it is calculated in a way that is similar to calculating the earnings per share.

[@mabedi94]

Where can I find more research on implied equity premiums? It seems like it can be a good indicator of how over/under valued the market can be. Somewhat like the CAPE ratio +Aswath Damodaran

[@siekphried]

Thanks, it was really helpful! In the case of calculating the premium with historical data as the mean of market return and bonds, for the bond part do I have to use YTM or the actual return of the price of the Bond? thanks again

[@karthikkailash535]

It seems like the implied equity risk premium calculation produces a lower discount rate or expected return when the market price is higher. Which would also produce a lower equity risk premium. Isn't it counter-intuitive that the average risk in equities goes DOWN when the price is higher relative to cash flows?

[@AkeemGreen]

You're ALMOST correct. Here, Professor Damodaran is assuming that a movement in stock prices is caused by a change in the risk of the stock, not the other way around. It would be far more accurate to measure risk separately from stock prices; however, there's no "risk data" that would tell us how risky investors think stocks are, only price data. Therefore, we must assume that investors reveal their risk preferences through their buying and selling behavior. Of course, investors could be wrong, which would make the models wrong. Healthy skepticism is a necessary quality for understanding pricing models.

[@karthikkailash535]

@@AkeemGreen thanks for the clarification. I guess what you are saying is investors' perception of risk is lower when stock prices are higher. That makes sense. What I have a hard time wrapping my head around is the circular nature of it. Equities in general are perceived as less risky, therefore equity valuations are higher. Put another way, I would like to do a self-contained "intrinsic" valuation that doesn't depend on the market perception of risk. But as you say there is no risk data, so maybe using the market's view as a starting point and then applying one's own judgement is the way to go.

[@irshviralvideo]

​@@AkeemGreen😮t55kj$$cuuuuupppupupupupu77ppp7ppp7pp7p7yp7p77pppp7jjuuuuuiiv

[@marianostone2285]

I´d like this video a 1,000,000 times (if possible)

[@jowovogo]

Now, here is a question if anyone can answer it: If you add country default risk to the risk-free US rate (and a possible inflation differential or similar) to arrive at a country-/currency-specific risk-free rate, and you add to it a beta-dependent equity market risk premium that is also dependent on the rating (i.e., credit default) of a country, would that not mean that you account for country default risk twice when calculating cost of quity? Edit: In a way, I am asking what the country risk premium talked about here reflects actually. I'd have expected it to reflect the premium asked to invest in equities in a certain country, but instead of default risk of the country in question, I had expected it to be more: like the uncertainty regarding economic policy that may affect the probability with which cashflows can be gained.

[@abhisekmishra9752]

hi, he had pointed that out in one of his other lectures. he had said, he has not considered other factors through ratings.. a caveat

[@pa4761]

At 11:02 why do you add the Brazil premium to the USA premium?

[@MrDfinance]

Being an emerging market, Brazil has a lower credit rating for its sovereign bond, than a mature market like the US, hence the need for a country specific equity risk premium (ERP). This is then added to the US ERP to get a synthetic Implied ERP for Brazil. Alternatively though, you can go ahead and calculate the Implied ERP for Brazil, if you're able to get the relevant inputs. This may be difficult, as analyst estimates for growth in emerging market indices may not be available too easily.

[@aroopmc]

Divesh Nair

[@vivekmandoth1]

Why do you think the risk free in reals doesn’t already include a default risk of Brazils credit rating? Doesn’t the spread between AAA rated country’s risk free rate and that of BBB rated country already consider this? If not why?

[@kedarpai3425]

Where can i get notes of all the material that Prof. Aswath Damodaran is using. Can someone help regarding this ?

[@amit9565]

why cant we consider dividend yield also as a cash out flow from company add into cost of equity?

[@dhruv__008]

I can see why you use the USA erp to calculate the erp for emerging market countries. It is extremely difficult to get reliable data for emerging market countries.

[@Yohasakura2005]

Anyone figured out of how to get the compounded growth rate of 5.27% at 7:22 in the video?

[@dodgingdurangos924]

Yohasakura He said he made projections based on analyst estimates and his own reasonable assumption considering current economic conditions at that time. 5.27% is his projected CAGR (compounded annual growth rate).

[@ChrisMorrisseyInvest]

He's also said you can work from average GDP growth.

[@womensfinancecoach4573]

Brilliant!Thank you!

[@pabloespinosa8691]

thanks for the video. Just two questions: whats the logic behind adding 5.8% (the risk premium in USA) to calculate the total equity risk premium for brazil (minute 11:00)? Whats the implied risk premium? how its caculated and can we use it as a risk premium?

[@TheAjw26]

The implied risk premium is the (forward-looking) discount rate imputed from the forecasted cash flows of an asset (in this case the S&P Index), LESS the risk-free rate. The cash flow forecast change according to market data and analyst estimates, while the risk-free rates change according to macroeconomics and gov policies. This is why it is dynamic and changes all the time. I use group averages of company-specific implied rates rather. Depends what you are valuing I guess. Hope that helps...

[@farazganji6203]

5.8% is the US implied ERP, when we don't have alot of data we start off with the established ERP (US is used in this case), then we add onto this 1.75% (the default spread for 10 year brazilian bond in excess of US bond as calculated by moody's) and this is scaled by the additional risk taken on by holding an equity which is quantified as the division between the SD of brazilian equity market and the SD of the brazilian bond market.

[@dollarbill8959]

Overcomplicated, there should be an easier way by using regressions. Rolling market volatility can be a good explanation variable for calculating the spread. It should be checked though.

[@liu9045]

How about companies like Tiktok? Its US operation is impacted by it being a Chinese company. Is it better to apply China CRP for all, or breakdown Chinese and US revenues and apply different CRP?

[@diegotorres4488]

If the ERP of a company like Coca Cola depends on where it does business. Does not the same thing happen to the rest of the S & P companies? So, the base line ERP calculated on the S & P companies is not really the weighted average ERP of where they do business? In this case there is no US ERP or at least I can not calculate it taking the American index companies. is my reasoning correct?

[@conorcrowley6504]

How can you find the revenue split by country for a company?

[@rohan4872]

Could anybody advise on how he solved for r? ie the 7.54% discount rate?

[@tonymakhula8913]

Rohan interpolation

[@rohan4872]

Sorry that doesn't answer my question.

[@x10mark24]

how do you treat country risk that stems from the government of the country that a company is headquartered in. for instance a company could be an oil exporter from somewhere in Latin america where Marxist "revolutions" seem a dime a dozen, one of the hallmarks of these governments is the nationalization of resource exportation enterprises, how do you calculate the risk that is added to a company not by the nations that it does business with but by the nation it is headquartered in?

[@lucasjullian5152]

Question: In the Equity Risk Premium Formula - what is r? I can't seem to get my head around how he gets to his 'Expected Return on Stocks = 7.54%). I understand all of the other values and cashflows, but can't seem to understand what this 'r' variable is? I'm not from a Maths background so forgive me if very obvious

[@michaelclark1845]

The r is the rate. The formula at the time you are referring is = cash flow / ((1+rate)^t)).... t being the time period

[@victorcabrejos3823]

so could i just put it in the regular ytm calculator

[@l96ai]

That risk free rate at 13:34, is it the rf of investor's country or target's country?

[@akm1657]

what's the use of calculating "total erp" . Are we going to use it in our calculation of E(R) for the companies, or are we going to use the erp of mature markets.

[@oompaloompa3730]

ERP is the premium you add to your Country's risk free rate to get the amount of return you would need to hold a risky(stocks) asset. ERP+Risk free rate is an estimate of your expected return. As he mentioned towards the end, he used a revenue weighted average of the ERP of the different countries and added that to the US Rf rate.

[@rohan4872]

This is slightly confusing in my mind. ERP you subtract from the risk free rate to get your market risk premium. Expected return is your cost of equity financing - ie what equity holders are expecting to receive no (CAPM)? That subsequently gets added back to your risk free rate and beta to get to your return on equity.

[@oompaloompa3730]

CAPM is just 1 way of findin ERP. There are multiple ways. This happens to be one of them.

[@rohan4872]

Yes - but in IB at least, we don't use anything else to derive ke except CAPM. Do you know how he he solved for r btw?

[@dodgingdurangos924]

Rohan I agree this was very confusing. For me, his accent, his tempo and rhythm in speaking makes it difficult to follow his intricate steps and details. If you were referring to solving for r in the slide @8:18, then I believe he used the IRR (Internal Rate of Return) method, which is synonymous to the yield-to-maturity method where the PV of cash flows minus intial investment = 0 = NPV. These are related to the NPV formula. Did you arrive to this conclusion?

[@invertirlo5890]

Could I use a discount rate as the return I want from a company?

[@invertirlo5890]

For example, if I want anual 20% from Apple, I calculate the cash flow with 20% directly

[@sohamsane3999]

no , you need to consider the market's expectations from the investment by looking at historical data and market conditions

[@Yohasakura2005]

How is country risk premium different from default spread?

[@iluvsquarez]

Yohasakura A default spread is, in a sense, the risk premium of taking on the DEBT of the country. Says the spread between U.S. and Italy is 1.5%, that's the premium charged for buying an Italian bond. But this video is about getting the equity risk premium.

[@14324srinivas]

Sir, according to the lamda formula(16:00), if a firm has %domestic revenues more than %domestic revenues of average firm in the country, then firms country risk premium(CRP) would be more than that of the countries CRP, Can you please explain the rationale, why CRP(firm)>CRP(country)

[@madraschap]

Because a bad event would affect the chosen firm more than the average firm in the country. Taking India as an example, an economic slowdown in India will affect Tata Motors more than Infosys, because the former has a greater lambda. So, the stock price of Tata Motors will fall more to increase the rate of return.

[@kenkrak4649]

Professor, why did you use the risk free rate as a proxy for the growth of the economy?

Interest rates pay a huge role in the pricing of bonds. When rates go up, prices go down and vice versa. Interest rates go up when the economy is doing well and inflation is on the rise and vice versa with deflation.

[@kenkrak4649]

@ That doesnt explain why it was used as a proxy for the growth of the economy though

[@marcuss3063]

At 9:36 you mention that everyone at the bank uses the historical risk premium of 4.2% and so everything looks cheap; as opposed to the implied premium of 5.8% you calculated. Doesn't this mean that companies will look more expensive using the historical premium? Since the S&P500's cash flows are discounted to a lesser extent.

[@shaileshtripathy8611]

No. Lower risk free premium will increase the asset's perceived intrinsic value, making it look cheap.

[@gowthamdhanasekaran3908]

What is 5.8% in Brazil?

[@AnonymousThinker-op3vr]

the updated equity premium of brazil from the earlier example

[@devmoudgill2903]

a session a day

[@availabilityavailabl]

why don't we just use the returns of say the S&P index and minus the risk free rate to get the market risk premium?

[@iluvsquarez]

availabilityavailabl you can. He explained it in the video. You can look at historic s&p500 returns, less the risk free rate over the same period, and that's the premium. But that's backward looking. He argues that we should use a forward looking implied premium versus the method you mentioned

[@Yohasakura2005]

What is 5.8% at 10:26?

[@madraschap]

U.S. equity risk premium which is used as a base for this calculation. Your aim is to add a country risk premium to the US risk premium. This is the proxy method to arrive at the equity premium for a country even when there's not enough data locally.

[@janvermaat1068]

I have a question professor, I was wondering how you computed the compounded annual growth rate? I tried different approaches, but I can't seem to get the number 5.27%. Let me explain, what I did: (1.0767 * 1.0728 * 1.0544 * 1.036 * 1.0176)^(1/5) = 1.0513, which is 5.13% and not 5.27%. This is when I assume that the growth linearly decreases in from year 2014 to 2017. If I assume linear decrease in growth rate from 2013 to 2017, I get a compounded annual growth of 4.47%. So my question is, how did he get the 5.27%? PS: I know the difference is small, but I believe it is an indication that either one of us is slightly off.

[@janvermaat1068]

I think you misunderstood my question. I did not say I had problems with "estimating growth rates". I said I have problems with the sentence: "resulting in a compounded annual growth rate of 5.27%" (see kzbin.info/www/bejne/i2SnapSVfcSJqNU). It is namely in my opinion not clear how it results to 5.27%. My problem is with his computation from growth rates to the compounded annual growth rate. This is entirely different from "how to estimate growth rates". My sincere apologies if my initial question was not clear enough.

[@ivanzhizhin6863]

The growth doesn't decrease linearly... I am also not sure why you try to work with the growth rates, instead of the the actual values (slide at 7:01) You then do the math (89.8/73.12)^1/4 - 1 = 0.0527

[@aleksandrsfilipovics7544]

Hello! How can I calculate scaling down rate? To find 1.0544 and 1.036...

[@nicosuave23]

He got that number by dividing the year by year cash flows that were expected to increase by 7.67% one year, 7.26% another down to 1.76% and averaged the earnings.

[@johnlettieri1274]

Did you ever figure this out? I completely understand what you mean.

[@xgum]

8:23 index what?

[@iluvsquarez]

Would you prefer I attempt at explaining what's going on in that slide?

[@leonardodavinci523]

@@iluvsquarez yea go for it...

[@iluvsquarez]

@@leonardodavinci523 the value of an asset (in this case an index like the S&P 500) is the present value of all expected future cash flows (which for the index, the cash flow an investor would get are dividends and buybacks). So the variables in the formula are: Asset Price, Expected Cash Flows, growth rate, and a discount rate. The price of the S&P 500 is available everyday. The current cash flow (dividends and buybacks) is avaliable as well. The growth rate is estimated by analysts. The only unknown here is the discount rate, which is the return on the S&P 500. Solve the formula for that return and that's your estimate for a forward looking market return on equity. You subtract the risk free rate to arrive at an estimate of the equity risk premium. Please note that the only values that is fixed are the price of the index and the dividends and buybacks that are actually paid out. The only assumption is the growth rate. That is the driver of the equity risk premium that you can control.

[@leonardodavinci523]

@@iluvsquarez oh my god, thank you thank you so much... I was stucked in this lecture I've already watched it like for 10 or 12 times but after your comment dang I get everything thank you bruh

[@amanpathak2889]

@@iluvsquarez, I have just one more doubt if you could please clarify it for me. We have the final maturity value when calculating yield to maturity for a bond. For example - A bond issued is at $100, whose coupon rate is 8%, and the current market price is $105 and is redeemable at $150 after 4 years. In this example, apart from cash flows, we also have redeemable value based on which we calculate yield to maturity. But here, when performing the same for equity, what is the redeemable value and how is Sir calculating that??

[@QQQQQman]

The starting point here is the cash returned to shareholders (in 2012) of "72.25" what is that - million, billion USD? which has then been adjusted by use of a 10-yr average down to 69.46. And more importantly, where is the source data for those numbers? If Factset, TR, well they are both subscription only. So not much use at all. This is a dead end before it has even begun, a Google search - to get this kind of data - is frankly, useless.

[@justagoose5528]

Did you find the source for those numbers?

[@Kaizen__trader]

I wish these could be in Hindi language also.

[@davidjukebox]

Does anyone know what the fuck Damodaran is talking about.. he talks at you like you should not what he is talking about and also like your an idiot at the same time; this is all new to me hence why taking the class - but he just flies through stuff as it you need to be versed in this and a tonnes of background finance and maths, did I miss a whole course providing the context FML. There was a slide on "An updated equity risk premium" and I literally could have punched the screen.

[@shivamshahorignal]

What nonsense , overcomplicating everything, just take the expected rate of inflation as the discount rate for all types of assets, and use margin of safety to deal with risk

[@harambenolevest69]

Snoozefest