Module II· Cost of Equity & CAPMIntermediate
Question
What is the difference between the historical and implied ERP, and which should you use?
Answer
Mechanics
Two methods for estimating the ERP:
- Historical ERP: realized excess return of equities vs. bonds over long periods (Dimson-Marsh-Staunton: 1900–today, one major developed market ~5.1%). Advantage: empirically measurable; drawback: backward-looking, survivorship bias, sensitive to the start point.
- Implied ERP: backed out from current equity prices + consensus EPS (Damodaran). Advantage: forward-looking; drawback: assumption-dependent, fluctuates month to month.
IB practice
Reference both; in a pitch typically 5.5–6.0% — a middle path that extrapolates neither hype nor crisis.