A Simple Methodology to Estimate the Prospective Equity Premium

Abstract

This paper sets out some simple, closed-form formulae to estimate the level of the prospective equity premium. The formulae are based on a comparison of the firm's cost of capital with the market discount rate. Calibration of the models over long time periods indicates that, in aggregate, firms have achieved a return on their investments that is below the market discount rate. This result is robust to differing time periods, model specifications, and return calculations. It is also consistent with existing evidence that: (a) in aggregate, investment and stock returns are negatively correlated; (b) stocks with high investment suffer low subsequent returns; (c) firms raising capital suffer low subsequent returns; and (d) firms returning capital to shareholders achieve high subsequent returns. Alternative explanations of this main result are also discussed, including the possibility that the earnings of firms, and hence the funds available for investment, have been overstated due to inflation or other factors. I also use the models to estimate annual levels of the prospective equity premium since 1949. This analysis indicates that the premium over long-term Treasuries has been low since the early-1980s.