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Deutsche Bank : Discussing the Equity Risk Premium

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Introduction

Case Report Deutsche Bank : Discussing the Equity Risk Premium Summary Jamil Baz, global head of fixed income research at Deutsche Bank, and George Cooper, global fixed income strategist of the same group, are finalizing a client presentation on the danger of overstating the Equity Risk Premium (ERP) when comparing bonds and equities. For this purpose, they evaluate two different approaches used to calculate the ERP. Identification of the problem The general idea behind the calculation of the Equity Risk Premium can be divided in 3 steps: � Estimation of the expected total return on stocks � Estimation of the expected risk-free return of bond coupons � Calculating the difference of the above two estimations Two approaches are proposed for estimating ERP - The first is called the Gordon Growth Model (GGM). It uses a dividend discount model in order to estimate the Equity Risk Premium. The expected total return on stocks (%) is considered equal to the summation of the dividend yield (%) and the expected growth in dividends (%). The second approach is based on the price-to-earnings ratio of the company and its reciprocal, the earnings yield. ...read more.

Middle

The parameters used in this method are independent and are not subject to economic conditions. In addition, the dividend payout ratio and dividend growth rate reflect the worth of different actions (including buy back stocks, reinvest, or pay dividend) and implicitly determine the current earnings yield. The Earnings Yield Method adjusted the original P/E of 19.3 to 29.3 with several corrections. The adjustment is missing one influencing factor: the impact of inflation on the real values of creditor claims. Modigliani and Cohn (1979) showed that GAAP-based earnings of leveraged companies overstate the cost of debt, because the value of the principal returned to creditors will be lower in real terms because of inflation than what they lent. Connection between the two models According to the Gordon Growth Model, current share price equals dividend divided by the difference between return on equity (ROE) and dividend growth rate (G). In theory, sustainable growth rate of a firm is the maximum growth rate that a firm can sustain without having to increase its financial leverage. If a firm never pays out dividend and retains all its earnings inside the firm, then its sustainable growth rate should just be as large as its ROE. ...read more.

Conclusion

The growth rate of the average dividend payout ratio of the entire market will be constant * That constant growth rate of dividend payout ratio will be equal to consensus forecast of GDP growth rate *The economy is in equilibrium, which means that companies are going to reinvest the retained earnings at whatever its own quoted P/E ratios are. Table 2. Standard Errors in Historical Risk Premiums1 Estimation Period Standard Error of Risk Premium Estimate 5 years 20%/ V5 = 8.94% 10 years 20%/ V10 = 6.32% 25 years 20% / V25 = 4.00% 50 years 20% / V50 = 2.83% 80 years 20% / V80 = 2.23 _________________________________________________________________________________ 1 Equity Risk Premium : Determinants, Estimation and Implications, Aswath Damodaran, Stern B.S. Table 3. Summary Statistics- U.S. Stocks, T.Bills and T. Bonds- 1928-20102 (to elaborate the high riskiness of investing in Stocks rather than bonds) Stocks T. Bills Bonds Mean 11.31% 3.70% 5.28% Standard Error 2.22% 0.33% 0.85% Median 14.22% 3.23% 3.61% Standard Deviation 20.21% 3.04% 7.74% Minimum -43.84% 0.03% -11.12% Maximum 52.56% 14.30% 32.81% _________________________________________________________________________________ 2 Equity Risk Premium : Determinants, Estimation and Implications, Aswath Damodaran, Stern B.S. ?? ?? ?? ?? ...read more.

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