Forward Looking Equity Risk Premium: A Normative Long-Term View

Abstract

We propose a Total Cash Flow present value model to estimate the implied risk premium equity indices typically used in financial models as proxies for the aggregate stock market. Following a bottom - up approach, we use individual companies’ financial information as well as analysts’ earnings estimates in order to reconstruct the index total cash flow and expected future cash flows. Using the prices for these indices, we then extract the implied Equity Risk Premia and analyze their evolution through time. To illustrate our approach, we run our model over a period of 10 years surrounding the 2008 financial crisis on five stock indices, namely the S & P 500, the Euro Stoxx 50, the FTSE 100, the Hang Seng Index and the TOPIX 100. We find that our model is a conceptually robust approach to modeling long-term market Equity Risk Premia and provides a normative view of expected returns for practitioners.