The Equity Risk Premium The Long-Run Future of the Stock Market

by Cornell, Bradford

• ISBN13: 9780471327356
• ISBN10: 0471327352
• Edition: 1st
• Format: Hardcover
• Copyright: 1999-05-26
• Publisher: Wiley

Summary

The Equity Risk Premium-the difference between the rate of return on common stock and the return on government securities-has been widely recognized as the key to forecasting future returns on the stock market. Though relatively simple in theory, understanding and making practical use of the equity risk premium concept has been dauntingly complex-until now. In The Equity Risk Premium, financial advisor, author, and scholar Bradford Cornell makes accessible for the first time an authoritative explanation of the equity risk premium and how it works in the real world. Step-by-step, his lucid, nontechnical presentation leads the reader to a new and more enlightened basis for making asset allocation choices. Cornell begins his analysis by looking at the equity risk premium in the light of stock market history. He examines the use of historical data in estimating future stock market performance, including the historical relationship between stock returns and risk premium, the impact of survival bias, and the effect of long-horizon stock and bond returns. Using the stock market boom of the 1990s as a case study, Cornell demonstrates what equity risk premium analysis can tell us about whether stock prices are high or low, whether the stock market itself may have changed, and whether indeed a new economic paradigm of higher earnings and dividend growth is now in place. Cornell analyzes forward-looking estimates of the equity risk premium through the lens of various competing approaches and assesses the relative merits of each. Among those scrutinized are the Discounted Cash Flow model, the Kaplan-Rubeck study, the Welch survey, and the Fama-French Aggregate IRR analysis. His insights on risk aversion theory, on the types of risk that have been rewarded over time, and on changing investor demographics all supply the sophisticated investor with important pieces of the risk premium puzzle. In his invaluable summing up of the equity risk premium and the long-run outlook for common stocks, Cornell weighs the evidence and assays the impact of a lower equity risk premium in the future-and its profound implications for investments, corporate decision making, and retirement planning. The product of years of serious analysis and hard-won insights, The Equity Risk Premium is essential reading for institutional investors, money managers, corporate financial officers, and all others who require a higher level of market analysis. "The Equity Risk Premium plays a critical role in legal and regulatory matters related to corporate finance. Along with the cost of debt, it is the most important determinant of a company's cost of capital. As such, it is an integral part of the decision-making process in corporate finance. For instance, whether or not a major acquisition makes sense can depend on the assumed value of the equity risk premium. In addition, the equity risk premium is an issue that regulatory bodies consider when they set fair rates of return for regulated companies. Cornell's book is an important contribution because it includes both an historical analysis of the equity risk premium and provides tools for forecasting reasonable levels of the risk premium in the years ahead."-Theodore N. Miller, Partner, Sidley & Austin. "Estimating how well stocks will do in the future from how well they have done in the past is like driving a car while looking in the rearview mirror. Brad Cornell provides us with an important forward-looking view in this easily understood guide to the equity risk premium and confounds the popular view that stocks will do well in the future because they have done well in the past."-Michael Brennan, Past President of the American Finance Association and Professor of Finance at the University of California at Los Angeles.

Author Biography

BRADFORD CORNELL is President of FinEcon Financial Economic Consulting and Professor of Finance at the Anderson Graduate School of Management at UCLA. A frequent contributor to professional and academic journals, his writing has also appeared in the Wall Street Journal and the Los Angeles Times. "An understanding of the equity risk premium is important for informed financial decision making. Cornell's book does an excellent job tying together historical, empirical, and theoretical analysis of the premium in a package accessible to practitioners as well as academics." -Eugene F. Fama, Robert R. McCormick Distinguished Service Professor of Finance, University of Chicago.

Table of Contents

Preface	ix
Acknowledgments	xi
Measuring and Assessing Stock-Market Performance	1	(35)
An Introduction to Stock-Market History	5	(13)
Stock-Market Indexes	6	(3)
Using Investor Returns to Assess Stock-Market Performance	9	(3)
An Overview of Market Performance: Annual Holding-Period Returns	12	(6)
The Equity Risk Premium	18	(2)
Definition	18	(1)
Importance	19	(1)
Using the Historical Data to Estimate Future Stock-Market Performance	20	(7)
Uses of the Equity Risk Premium	27	(2)
Inflation and Asset Returns	29	(5)
Stock Returns and the Risk Premium: Looking Forward	34	(2)
Evaluating the Historical Record	36	(65)
Computing the Average Premium: Arithmetic versus Geometric	36	(3)
How Accurately Can the Historical Risk Premium Be Measured?	39	(6)
Nonstationarity and Historical Estimates of the Equity Risk Premium	45	(4)
Attempts to Model Changes in the Risk Premium	49	(11)
Models Based on the Variability of Returns	51	(1)
Models Based on Dividend and Earnings Yield	52	(1)
Does Nonstationarity Really Matter for Estimating the Long-Run Risk Premium?	53	(2)
The Impact of Permanent Changes in the Risk Premium on Stock Prices	55	(4)
The Bottom Line on Nonstationarity	59	(1)
Survival Bias	60	(10)
The Impact	60	(9)
The Bottom Line	69	(1)
Stock and Bond Returns	70	(7)
Over the Long Horizon	70	(4)
The Impact of Inflation	74	(3)
A Final Assessment of the Historical Record	77	(2)
Appendix 2.1: Monthly Data for Stocks, Bonds, Bills, and Inflation	79	(22)
Forward-Looking Estimates of the Equity Risk Premium	101	(25)
The Discounted Cash Flow Model	102	(12)
Forms of the Model	102	(1)
Constant-Growth Form	102	(4)
Multistage Form	106	(7)
Comparison of the Discounted Cash Flow and Historical Estimates of the Risk Premium	113	(1)
The Blanchard Extension of the Discounted Cash Flow Approach	114	(1)
The Kaplan--Ruback Study	115	(2)
The Fama--French Aggregate Internal Rate of Return Analysis	117	(4)
An Earnings Yield Approach to Estimating the Market Risk Premium	121	(1)
The Welch Survey	122	(3)
Summary of the Risk Premium Estimates Produced by Competing Approaches	125	(1)
Risk Aversion and the Risk Premium Puzzle	126	(32)
The Economic Theory of Risk Aversion	126	(4)
What Types of Risk Are Rewarded: A Brief Review of Portfolio Theory	130	(5)
The Market Risk Premium and the Cost of Equity Capital	135	(2)
Risk Aversion and the Historical Equity Risk Premium: The Risk Premium Puzzle	137	(4)
Explanations for the Risk Premium Puzzle
The Puzzle Is an Illusion: The Empirical Data Are Wrong	141	(1)
High Risk Aversion	142	(3)
Nonstandard Utility Functions	145	(4)
Autocorrelation in Returns	149	(1)
Time Varies Expected Returns	150	(1)
Heterogeneous Investors	151	(3)
What about a Stew?	154	(1)
What Explanations of the Equity Risk Premium Say about the Future	154	(4)
The Risk Premium and the Stock-Market Boom of the 1990s	158	(43)
Determining Whether Stock Prices Are High or Low	159	(5)
Explanations for the High Level of Stock Prices	164	(30)
A Decline in the Discount Rate Due to a Drop in the Equity Risk Premium	165	(3)
Changing Stock-Market Risk	168	(2)
Changing Investors and Changing Investor Demographics	170	(8)
The New Economic Paradigm: Higher Earnings and Dividend Growth	178	(5)
Irrational Exuberance: The Market Is Overvalued	183	(11)
Summary	194	(2)
Appendix 5.1: International Stock Market Indices	196	(5)
The Equity Risk Premium and the Long-Run Outlook for Common Stocks	201	(16)
Weighing the Empirical and Theoretical Evidence	202	(4)
What Does the Stock Price Run-Up of the 1990s Augur for the Future?	206	(7)
The Impact of a Rational Drop in the Equity Risk Premium	206	(4)
The Impact of Permanently Higher Growth	210	(1)
The Implications of Overvaluation	211	(2)
Summary	213	(1)
Implications of a Lower Equity Risk Premium in the Future	213	(4)
Investment Implications	213	(2)
Implications for Corporate Financial Decision Making	215	(1)
Implications for Pension and Retirement Planning	216	(1)
References	217	(6)
Index	223