The solution to 1 states that a 2.5% equity risk premium, at the upper end of the client’s range, is justified by the positive economic outlook.
Is it not logical to assume that positive outlook > greater demand for stocks / risky assets (less risk aversion) > lower risk premium?
hence why isnt the 1% premium (at the lower end of the range) more appropriate?
if you did the 1% ERP - e.g.
your discount rate will be lower, so your Equity Valuation will be higher… more aggressive valuation.
but with the higher ERP -> 2.5% -> your equity valuation will be lower… and more conservative.
Remember rate is used in the denominator.
thanks cpk, but if the economic outlook is good, there is more demand for equities, so higher prices (more aggressive valuation) implying lower discount rate i.e. 1% ERP. am i getting this wrong?
Remember the risk premium is the ( r - g ) term. The r is the implied discount rate for Equities , while the g is the growth rate of equities. If g is high the premium will be lower. But the very first thing the table says is that the long term economic outlook is for slower growth : "Overall economic growth rate to slow to a lower rate beyond the 1-year time horizon ". So the g is slowing , and the risk premium is increasing even with the discount rate constant.
The discount rate of equities is likely to be higher in the short term because of inflationary outlook in the near term . However this is expected to stabilize , so r may not increase much . Due to lower g the premium should rise
. Since the client asked if 1% or 2.5% is more feasible , Mr. Wu selects the higher , more as a signal ( no calculations are shown )
thanks.
sorry for not quite getting this, but how is risk premium the (r-g) term? isnt (r-g) the dividend yield?
I believe it is more to do with long term expectations vs. short term. On the table on the next page they talk of slowing economy - going down to 3.1% growth. So in the long run - that is not going to signal a good thing. While short term expectations may be good - that is where you do tactical allocation. For Strategic allocation - you need the long term in mind, and for that conservatism with a higher r -> hence 2.5% ERP.
there is some evidence that the long term real growth rate of equities is equal to the risk free rate . So if equity premium is taken as the discount rate for equities minus the risk free rate , then indeed the dividend yield is the same as the equity risk premium .
awesome. thanks for your inputs.