Wednesday, 15 April 2020

Implied Equity Risk Premium for S & P BSE Sensex

Based on Prof. Damodaran's implied equity risk premium for the US market, an equity risk premium for the Indian equity market has been calculated in the spread sheet below. For the calculation of historical equity risk premiums actual dividend yields, nominal growth rate and the yield on 10-year benchmark bond for the respective years have been used.

Implied ERP for S & P BSE Sensex

The methodology for the calculation of ERP is available on Prof. Damodaran's blog. 

Implied equity risk premiums are akin to bond yields for bonds, they are inversely proportional to stock prices or index level.

Current implied equity risk premium is 1.13% which is actually lower than previous estimates  since earnings growth rate (nominal GDP growth rate) has been slashed to 6% for the current year due to covid-19, 10.5% for the subsequent years before reaching a steady state growth rate of 6% in the long term. The average implied ERP for the period 2010 to 2019 is 2.23% vs the current ERP of 1.13%.
If the current estimate of 1.13% is correct then there is scope for further correction in the Indian equity markets based on the reduced growth estimates.

The implied ERP  is subject to your assumptions of growth and dividend payout.

 Reading Equity Risk Premiums 

In this chart, Prof. superimposed equity risk premiums and BBB bond spreads in the same graph. There are multiple takeaways from this chart for practitioners of finance and economics and  the rest of the article is devoted to describing some of these key insights provided by Prof. 

Equity Risk Premiums can be used to gauge overheating in the stock markets. For example, in 1999
equity risk premiums touched a low of 2% . This was at the peak of dot com bust and the expected returns on equity were very low which hinted at unreasonable price levels. So whenever ERPs reach historically low levels, investors need to get cautious and reduce risk taking.

Also notice that equity risk premiums and bond spreads on BBB bonds intersected in 1999 and 2008.
Under normal circumstances, the required rate of return on equity must be higher than the return on bonds. But when these curves intersect, chances are that either the equity prices are inflated (1999) or bond markets are in panic (2008).

Also notice the decline in bond spreads between 2002 and 2007, this period has been dubbed by market participants as 'Greenspan put' which resulted in the sub prime crisis.

So the bottom line here is that equity risk premiums and bond default spreads need to stay in balance with appropriate reward to risk ratio. If that is not the case, then there could be an asset price correction looming round the corner.

Data Source: S & P Indices, Yahoo Finance, Google Search

Investors' discretion is advised.

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