Equity Risk Premium in Pakistan: Comparative Estimates from Historical Returns, Dividend and Earnings Models

Abstract

This paper compares the efficiencies of dividend and earnings growth models with a historical model in predicting the unconditional expected equity risk premium (ERP). Monthly data has been used from the period 2010 to 2018 from 2 sectors namely market (KSE100 Index), cement and banking. The research applies a two-step process. First, we estimate and compare the absolute expected ERP under three models: (a) dividend growth model (Gordon, 1959), (b) earnings growth model and (c) historical returns, to find out the most efficient model for forecast ERP. Next, the effectiveness of the model is tested using a panel regression analysis. ERPs have been calculated with two different mathematical approaches, a simple return and continuously compounding returns (log returns). The results show that the dividend growth model emerges as the most efficient model for 1. KSE100 Index’s, 2.commercial bank and 3. Cement sector for predicting ERP and hence, investors should follow dividend policy to value Pakistani companies.