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Abstract
Research on the implied cost of capital (ICC) has found that the equity risk premium is approximately 3%, on average, much lower than estimates based on the mean of historical stock market returns. The validity of such ICC estimates, however, faces both theoretical and empirical challenges. The theoretical equivalence between ICC and expected return requires the stringent condition that the latter is a constant, which is inconsistent with theory and empirical evidence. The empirical estimation of ICC depends on short-run and long-run earnings forecasts, whose biases can severely limit the validity of the estimates. By employing a forecasting procedure that induces little bias in both short-run and long-run forecasts and taking into account the stochastic nature of expected returns, we show that the average market risk premium ranges between 3% and 6%. We also demonstrate that the results of prior research are affected by input errors that are partially self-canceling.
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