Estimating the Market Risk Premium (2)
by MaestroForward-Looking Risk Premiums An alternative to the historical risk premium is to estimate a forward-looking, or ex ante, risk premium. The most common approach is to use the discounted cash flow (DCF) model to estimate the expected market rate of return, ˆrM rM, and then calculate RPM as rM rRF.
In words, the required return on the market is the sum of the expected dividend yield plus the expected growth rate. Note that the expected dividend yield, D1/P0, can be found using the current dividend yield and the expected growth rate: D1/P0 D0(1 g)/P0. Therefore, to estimate the required return on the market, all you need are estimates of the current dividend yield and the expected growth rate in dividends. Several data sources report the current dividend yield on the market, as measured by the S&P 500. For example, Yahoo! reports a current dividend yield of 1.78 percent for the S&P 500. Yahoo! also reports a 9.03 percent annual growth rate of dividends for the S&P 500 during the past five years. However, we need the expected future growth in dividends, not the past growth rate.
To the best of our knowledge, there are no free sources that report analysts’ estimates of the expected future dividend growth rates for the S&P 500. Although we can’t find the S&P 500’s expected dividend growth rate, there are sources that report the S&P 500’s expected earnings growth rate. For example, Yahoo! reports a 13.03 percent estimate for the S&P 500’s expected annualized earnings growth rate.
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