0.

00%

-2.00%
Japanese Yen
Czech Koruna
Swiss Franc
Euro
Danish Krone
Swedish Krona
Taiwanese $
Hungarian Forint
Bulgarian Lev
Kuna
Thai Baht
BriOsh Pound
Romanian Leu
Norwegian Krone
HK $
Israeli Shekel
Polish Zloty
Canadian $
Korean Won
US $
Singapore $
Phillipine Peso
Pakistani Rupee
Venezuelan Bolivar
Vietnamese Dong
Australian $
Malyasian Ringgit
Chinese Yuan
NZ $
Chilean Peso
Iceland Krona
Peruvian Sol
Mexican Peso
Colombian Peso
Indonesian Rupiah
Indian Rupee
Turkish Lira
South African Rand
Kenyan Shilling
Reai
Naira
Russian Ruble

Risk free Rates in January 2015

98

Riskfree Rates: January 2015

14.00%

12.00%

10.00%

8.00%

6.00%

4.00%

2.00%

Risk free Rate

Aswath Damodaran
98

Measurement of the risk premium

99

The risk premium is the premium that investors

demand for invesOng in an average risk investment,
relaOve to the riskfree rate.
As a general proposiOon, this premium should be

greater than zero

increase with the risk aversion of the investors in that

market
increase with the riskiness of the average risk
investment

Aswath Damodaran

99

What is your risk premium?

Assume that stocks are the only risky assets and that you are
oered two investment opOons:

a riskless investment (say a Government Security), on which you can

make 3%
a mutual fund of all stocks, on which the returns are uncertain

How much of an expected return would you demand to shid

your money from the riskless asset to the mutual fund?
a.
b.
c.
d.
e.
f.

Less than 3%
Between 3% - 5%
Between 5% - 7%
Between 7% -9%
Between 9%- 11%
More than 11%

Aswath Damodaran

100

Risk Aversion and Risk Premiums

101

If this were the enOre market, the risk premium

would be a weighted average of the risk premiums
demanded by each and every investor.
The weights will be determined by the wealth that
each investor brings to the market. Thus, Warren
Buegs risk aversion counts more towards
determining the equilibrium premium than yours
and mine.
As investors become more risk averse, you would
expect the equilibrium premium to increase.

Aswath Damodaran

101

Risk Premiums do change..

102

Go back to the previous example. Assume now that

you are making the same choice but that you are
making it in the adermath of a stock market crash (it
has dropped 25% in the last month). Would you
change your answer?
a.
b.
c.

I would demand a larger premium

I would demand a smaller premium
I would demand the same premium

Aswath Damodaran

102

EsOmaOng Risk Premiums in PracOce

103

Survey investors on their desired risk premiums and

use the average premium from these surveys.
Assume that the actual premium delivered over long
Ome periods is equal to the expected premium - i.e.,
use historical data
EsOmate the implied premium in todays asset
prices.

Aswath Damodaran

103

The Survey Approach

104

Surveying all investors in a market place is impracOcal.

However, you can survey a few individuals and use these results. In
pracOce, this translates into surveys of the following:

The limitaOons of this approach are:

There are no constraints on reasonability (the survey could produce

negaOve risk premiums or risk premiums of 50%)
The survey results are more reecOve of the past than the future.
They tend to be short term; even the longest surveys do not go beyond
one year.

Aswath Damodaran

104

The Historical Premium Approach

105

This is the default approach used by most to arrive at the

premium to use in the model
In most cases, this approach does the following

Denes a Ome period for the esOmaOon (1928-Present, last 50 years...)

Calculates average returns on a stock index during the period
Calculates average returns on a riskless security over the period
Calculates the dierence between the two averages and uses it as a
premium looking forward.

The limitaOons of this approach are:

it assumes that the risk aversion of investors has not changed in a

systemaOc way across Ome. (The risk aversion may change from year
to year, but it reverts back to historical averages)
it assumes that the riskiness of the risky porlolio (stock index) has
not changed in a systemaOc way across Ome.

Aswath Damodaran

105

The Historical Risk Premium

Evidence from the United States
106

Arithmetic Average
Geometric Average

Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds

1928-2014
8.00%
6.25%
6.11%
4.60%

2.17%
2.32%

1965-2014
6.19%
4.12%
4.84%
3.14%

2.42%
2.74%

2005-2014
7.94%
4.06%
6.18%
2.73%

6.05%
8.65%

What is the right premium?

Go back as far as you can. Otherwise, the standard error in the esOmate will be
large.
Std Error in estimate =

Annualized Std deviation in Stock prices

)
Number of years of historical data

Be consistent in your use of a riskfree rate.

Use arithmeOc premiums for one-year esOmates of costs of equity and geometric
premiums for esOmates of long term costs of equity.

Aswath Damodaran

106

What about historical premiums for other

markets?
107

Historical data for markets outside the United States

is available for much shorter Ome periods. The
problem is even greater in emerging markets.
The historical premiums that emerge from this data
reects this data problem and there is much greater
error associated with the esOmates of the
premiums.

Aswath Damodaran

107

One soluOon: Bond default spreads as CRP

November 2013

In November 2013, the historical risk premium for the US was 4.20%
(geometric average, stocks over T.Bonds, 1928-2012)

Arithmetic Average
Geometric Average

Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds

1928-2012
7.65%
5.88%
5.74%
4.20%

2.20%
2.33%

Using the default spread on the sovereign bond or based upon the
sovereign raOng and adding that spread to the mature market premium
(4.20% for the US) gives you a total ERP for a country.
Country
India
China
Brazil

RaOng Default Spread (Country Risk Premium)

Baa3
2.25%
Aa3
0.80%
Baa2
2.00%

If you prefer CDS spreads:

Country
India
China
Brazil

US ERP Total ERP for country

4.20%
6.45%
4.20%
5.00%
4.20%
6.20%

Aswath Damodaran

Sovereign CDS Spread

4.20%
1.20%
2.59%

US ERP Total ERP for country

4.20%
8.40%
4.20%
5.40%
4.20%
6.79%

108

Beyond the default spread? EquiOes are

riskier than bonds

While default risk spreads and equity risk premiums are highly correlated,
one would expect equity spreads to be higher than debt spreads. One
approach to scaling up the premium is to look at the relaOve volaOlity of
equiOes to bonds and to scale up the default spread to reect this:
Brazil: The annualized standard deviaOon in the Brazilian equity index
over the previous year is 21 percent, whereas the annualized standard
deviaOon in the Brazilian C-bond is 14 percent.

! 21% $
Brazil's Total Risk Premium = 4.20% + 2.00%#
& = 7.20%
" 14% %

Using the same approach for China and India:

! 24% $
Equity Risk PremiumIndia = 4.20% + 2.25%#
& = 7.80%
" 17% %
! 18% $
Equity Risk PremiumChina = 4.20% + 0.80%#
& = 5.64%
" 10% %

Aswath Damodaran

109

Implied ERP in November 2013: Watch

what I pay, not what I say..

If you can observe what investors are willing to pay

for stocks, you can back out an expected return from
that price and an implied equity risk premium.

Base year cash flow (last 12 mths)

Dividends (TTM):
33.22
+ Buybacks (TTM):
49.02
= Cash to investors (TTM): 82.35
Earnings in TTM:
E(Cash to investors)

Expected growth in next 5 years

Top down analyst estimate of
earnings growth for S&P 500 with
stable payout: 5.59%
91.82

86.96

S&P 500 on 11/1/13=

1756.54
1756.54 =

96.95

102.38

108.10

86.96 91.82 96.95 102.38 108.10

110.86
+
+
+
+
+
2
3
4
5
(1+ r) (1+ r) (1+ r) (1+ r) (1+ r) (r .0255)(1+ r)5

Beyond year 5
Expected growth rate =
Riskfree rate = 2.55%
Expected CF in year 6 =
108.1(1.0255)

r = Implied Expected Return on Stocks = 8.04%

Minus
Risk free rate = T.Bond rate on 1/1/14=2.55%
Equals

Aswath Damodaran

Implied Equity Risk Premium (1/1/14) = 8.04% - 2.55% = 5.49%

110

The bogom line on Equity Risk Premiums

in November 2013

Mature Markets: In November 2013, the number that we chose to use as the
equity risk premium for all mature markets was 5.5%. This was set equal to the
implied premium at that point in Ome and it was much higher than the historical
risk premium of 4.20% prevailing then (1928-2012 period).

Arithmetic Average
Geometric Average

Stocks - T. Bills Stocks - T. Bonds Stocks - T. Bills Stocks - T. Bonds

1928-2012
7.65%
5.88%
5.74%
4.20%

2.20%
2.33%

1962-2012
5.93%
3.91%
4.60%
2.93%

2.38%
2.66%

2002-2012
7.06%
3.08%
5.38%
1.71%

5.82%
8.11%

For emerging markets, we will use the melded default spread approach (where
default spreads are scaled up to reect addiOonal equity risk) to come up with the
addiOonal risk premium that we will add to the mature market premium. Thus,
markets in countries with lower sovereign raOngs will have higher risk premiums
that 5.5%.
Emerging Market ERP = 5.5% +

Aswath Damodaran

!
$
Equity
&& !
Country Default Spread*##
" Country Bond %

111

A Composite way of esOmaOng ERP for

countries
Step 1: EsOmate an equity risk premium for a mature market. If your
preference is for a forward looking, updated number, you can
esOmate an implied equity risk premium for the US (assuming that
you buy into the contenOon that it is a mature market)

My esOmate: In November 2013, my esOmate for the implied premium in

the US was 5.5%. That will also be my esOmate for a mature market ERP.

Step 2: Come up with a generic and measurable deniOon of a mature

market.

My esOmate: Any AAA rated country is mature.

Step 3: EsOmate the addiOonal risk premium that you will charge for
markets that are not mature. You have two choices:

The default spread for the country, esOmated based either on sovereign
raOngs or the CDS market.
A scaled up default spread, where you adjust the default spread upwards
for the addiOonal risk in equity markets.

Aswath Damodaran

112

ERP : Nov 2013

Andorra
Austria
Belgium
Cyprus
Denmark
Finland
France
Germany
Greece
Iceland
Ireland
Italy

Canada
United States of America
North America

7.45%
5.50%
6.70%
22.00%
5.50%
5.50%
5.95%
5.50%
15.63%
8.88%
9.63%
8.50%
5.50%
5.50%
5.50%

1.95% Liechtenstein
5.50% 0.00% Albania
0.00% Luxembourg
5.50% 0.00% Armenia
1.20% Malta
7.45% 1.95% Azerbaijan
16.50% Netherlands
5.50% 0.00% Belarus
0.00% Norway
5.50% 0.00% Bosnia
0.00% Portugal
10.90% 5.40% Bulgaria
0.45% Spain
8.88% 3.38% CroaOa
Czech Republic
0.00% Sweden
5.50% 0.00%
Estonia
10.13% Switzerland
5.50% 0.00%
Georgia
3.38% Turkey
8.88% 3.38% Hungary
4.13% United Kingdom
5.95% 0.45% Kazakhstan
3.00% Western Europe 6.72% 1.22% Latvia

0.00%
0.00%
0.00%

ArgenOna
15.63% 10.13%
Belize
19.75% 14.25%
Bolivia
10.90% 5.40%
Brazil
8.50% 3.00%
Chile
6.70% 1.20%
Colombia
8.88% 3.38%
Costa Rica
8.88% 3.38%
Ecuador
17.50% 12.00%
El Salvador
10.90% 5.40%
Guatemala
9.63% 4.13%
Honduras
13.75% 8.25%
Mexico
8.05% 2.55%
Nicaragua
15.63% 10.13%
Panama
8.50% 3.00%
Paraguay
10.90% 5.40%
Peru
8.50% 3.00%
Suriname
10.90% 5.40%
Uruguay
8.88% 3.38%
Aswath Damodaran
Venezuela
12.25% 6.75%
La;n America 9.44% 3.94%

Country
Angola
Benin
Botswana
Burkina Faso
Cameroon
Cape Verde
Egypt
Gabon
Ghana
Kenya
Morocco
Mozambique
Namibia
Nigeria
Rwanda
Senegal
South Africa
Tunisia
Uganda
Zambia
Africa

TRP
CRP
10.90% 5.40%
13.75% 8.25%
7.15% 1.65%
13.75% 8.25%
13.75% 8.25%
12.25% 6.75%
17.50% 12.00%
10.90% 5.40%
12.25% 6.75%
12.25% 6.75%
9.63% 4.13%
12.25% 6.75%
8.88% 3.38%
10.90% 5.40%
13.75% 8.25%
12.25% 6.75%
8.05% 2.55%
10.23% 4.73%
12.25% 6.75%
12.25% 6.75%
11.22% 5.82%

12.25%
10.23%
8.88%
15.63%
15.63%
8.50%
9.63%
6.93%
6.93%
10.90%
9.63%
8.50%
8.50%
Lithuania
8.05%
Macedonia
10.90%
Moldova
15.63%
Montenegro
10.90%
Poland
7.15%
Romania
8.88%
Russia
8.05%
Serbia
10.90%
Slovakia
7.15%
Slovenia
9.63%
Ukraine
15.63%
E. Europe & Russia 8.60%

6.75%
4.73%
3.38%
10.13%
10.13%
3.00%
4.13%
1.43%
1.43%
5.40%
4.13%
3.00%
3.00%
2.55%
5.40%
10.13%
5.40%
1.65%
3.38%
2.55%
5.40%
1.65%
4.13%
10.13%
3.10%

Bangladesh
Cambodia
China
Fiji
Hong Kong
India
Indonesia
Japan
Korea
Macao
Malaysia
MauriOus
Mongolia
Pakistan
Papua NG
Philippines
Singapore
Sri Lanka
Taiwan
Thailand
Vietnam
Asia

10.90%
13.75%
6.94%
12.25%
5.95%
9.10%
8.88%
6.70%
6.70%
6.70%
7.45%
8.05%
12.25%
17.50%
12.25%
9.63%
5.50%
12.25%
6.70%
8.05%
13.75%
7.27%

5.40%
8.25%
1.44%
6.75%
0.45%
3.60%
3.38%
1.20%
1.20%
1.20%
1.95%
2.55%
6.75%
12.00%
6.75%
4.13%
0.00%
6.75%
1.20%
2.55%
8.25%
1.77%

Bahrain
8.05% 2.55%
5.50% 0.00%
Israel
6.93% 1.43% Australia
12.25% 6.75%
Jordan
12.25% 6.75% Cook Islands
5.50% 0.00%
Kuwait
6.40% 0.90% New Zealand
Lebanon
12.25% 6.75% Australia & NZ 5.50% 0.00%
Oman
6.93% 1.43%
Qatar
6.40% 0.90%
Saudi Arabia
6.70% 1.20%
United Arab Emirates 6.40% 0.90% Black #: Total ERP
Middle East
6.88% 1.38% Red #: Country risk premium
AVG: GDP weighted average

EsOmaOng ERP for Disney: November 2013

IncorporaOon: The convenOonal pracOce on equity risk premiums is to

esOmate an ERP based upon where a company is incorporated. Thus, the
cost of equity for Disney would be computed based on the US equity risk
premium, because it is a US company, and the Brazilian ERP would be
used for Vale, because it is a Brazilian company.
OperaOons: The more sensible pracOce on equity risk premium is to
esOmate an ERP based upon where a company operates. For Disney in
2013:
Region/ Country
US& Canada
Europe
Asia-Pacic
LaOn America
Disney

Aswath Damodaran

Proportion of Disneys
Revenues
82.01%
11.64%
6.02%
0.33%
100.00%

ERP
5.50%
6.72%
7.27%
9.44%
5.76%
114

ERP for Companies: November 2013

Company
Bookscape

Vale

In November 2013,
the mature market
premium used was
5.5%
Tata Motors

Baidu

Deutsche Bank

Aswath Damodaran

Region/ Country
United States
US & Canada
Brazil
Rest of Latin
America
China
Japan
Rest of Asia
Europe
Rest of World
Company
India
China
UK
United States
Mainland Europe
Rest of World
Company
China
Germany
North America
Rest of Europe
Asia-Pacific
South America
Company

Weight
100%
4.90%
16.90%

ERP
5.50%
5.50%
8.50%

1.70%

10.09%

37.00%
10.30%
8.50%
17.20%
3.50%
100.00%
23.90%
23.60%
11.90%
10.00%
11.70%
18.90%
100.00%
100%
35.93%
24.72%
28.67%
10.68%
0.00%
100.00%

6.94%
6.70%
8.61%
6.72%
10.06%
7.38%
9.10%
6.94%
5.95%
5.50%
6.85%
6.98%
7.19%
6.94%
5.50%
5.50%
7.02%
7.27%
9.44%
6.12%

115

The Anatomy of a Crisis: Implied ERP from

September 12, 2008 to January 1, 2009
116

Aswath Damodaran

116

An Updated Equity Risk Premium: January

2015
Base year cash flow (last 12 mths)
Dividends (TTM):
38.57
+ Buybacks (TTM):
61.92
= Cash to investors (TTM): 100.50
Earnings in TTM:
114.74
E(Cash to investors)

100.5 growing @
5.58% a year

112.01

106.10

S&P 500 on 1/1/15=

2058.90
2058.90 =

Expected growth in next 5 years

Top down analyst estimate of earnings
growth for S&P 500 with stable
payout: 5.58%

118.26

124.85

131.81

106.10 112.91 118.26 124.85 131.81 131.81(1.0217)

+
+
+
+
+
(1+ r) (1+ r)2 (1+ r)3 (1+ r)4 (1+ r)5 (r .0217)(1+ r)5

Beyond year 5
Expected growth rate =
Riskfree rate = 2.17%
Expected CF in year 6 =
131.81(1.0217)

r = Implied Expected Return on Stocks = 7.95%

Minus
Risk free rate = T.Bond rate on 1/1/15= 2.17%
Equals
Implied Equity Risk Premium (1/1/15) = 7.95% - 2.17% = 5.78%

Aswath Damodaran

117

4.00%

3.00%
Implied Premium

Implied Premiums in the US: 1960-2014

118

Implied Premium for US Equity Market: 1960-2014

7.00%

6.00%

5.00%

2.00%

1.00%

2014
2013
2012
2011
2010
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
1989
1988
1987
1986
1985
1984
1983
1982
1981
1980
1979
1978
1977
1976
1975
1974
1973
1972
1971
1970
1969
1968
1967
1966
1965
1964
1963
1962
1961
1960
0.00%

Year

118
Aswath Damodaran