In theory, stocks should provide a greater return than safe investments like Treasury bonds. The difference is called the equity risk premium: it is the excess return that you can expect from the overall market above a riskfree return. There is vigorous debate among experts about the method employed to calculate the equity premium and, of course, the resulting answer. In this article, we take a look at these methods  particularly the popular supplyside model  and the debates surrounding equity premium estimates.
Why Does It Matter?
The equity premium helps to set portfolio return expectations and determine asset allocation policy. A higher premium, for instance, implies that you would invest a greater share of your portfolio into stocks. Also, the capital asset pricing relates a stock's expected return to the equity premium: a stock that is riskier than the market  as measured by its beta  should offer excess return above the equity premium.
Greater Expectations
Compared to bonds, we expect extra return from stocks due to the following risks:
 Dividends can fluctuate, unlike predictable bond coupon payments.
 When it comes to corporate earnings, bond holders have a prior claim while common stock holders have a residual claim.
 Stock returns tend to be more volatile (although this is less true the longer the holding period).
And history validates theory. If you are willing to consider holding periods of at least 10 or 15 years, U.S. stocks have outperformed treasuries over any such interval in the last 200 years.
But history is one thing, and what we really want to know is tomorrow's equity premium. Specifically, how much extra above a safe investment should we expect for the stock market going forward? Academic studies tend to arrive at lower equity risk premium estimations  in the neighborhood of 23%, or even lower! Later in this article, we'll explain why this is always the conclusion of an academic study, whereas money managers often point to recent history and arrive at higher estimations of premiums.
Getting at the Premium
Here are the four ways to estimate the future equity risk premium:
What a range of outcomes! Opinion surveys naturally produce optimistic estimates, as do extrapolations of recent market returns. But extrapolation is a dangerous business: first, it depends on the time horizon selected, and second, we cannot know that history will repeat itself. Professor William Goetzmann of Yale has cautioned, "History, after all, is a series of accidents; the existence of the time series since 1926 might itself be an accident." For example, one widely accepted historical accident concerns the abnormally low longterm returns to bondholders that started right after World War II (and subsequently low bond returns increased the observed equity premium); bond returns were low in part because bond buyers in the 1940s and 1950s  misunderstanding government monetary policy  clearly did not anticipate inflation.
Building a Supply Side Model
Let's review the most popular approach, which is to build a supplyside model. There are three steps:
 Estimate the expected total return on stocks.
 Estimate the expected riskfree return (bond).
 Find the difference: expected return on stocks minus riskfree return equals the equity risk premium.
We'll keep it simple and sidestep a few technical issues. Specifically, we are looking at expected returns that are longterm, real, compound and pretax. By longterm, we mean something like 10 years, as short horizons raise questions of market timing. (That is, it is understood that markets will be over or undervalued in the short run.)
By 'real', we mean net of inflation. Even if we estimated the stock and bond returns in nominal terms, inflation would fall out of the subtraction anyhow. And by 'compound', we mean to ignore the ancient question of whether forecasted returns ought to be calculated as arithmetic or geometric (timeweighed) averages.
Finally, although it is convenient to refer to pretax returns as do virtually all academic studies, individual investors should care about aftertax returns. Taxes make a difference. Let's say the riskfree rate is 3% and the expected equity premium is 4%; we therefore expect equity returns of 7%. Say we earn the riskfree rate entirely in bond coupons taxed at ordinary income tax rates of 35%, whereas equities may be deferred entirely into a capital gains rate of 15% (i.e., no dividends). The aftertax picture in this case makes equities look even better.
Step One: Estimate the Expected Total Return on Stocks
DividendBased Approach The two leading supplyside approaches start with either dividends or earnings. The dividendbased approach says that returns are a function of dividends and their future growth. Consider an example with a single stock that today is priced at $100, pays a constant 3% dividend yield (dividend per share divided by stock price), but for which we also expect the dividend  in dollar terms  to grow at 5% per year. In this example, you can see that if we grow the dividend at 5% per year and insist on a constant dividend yield, the stock price must go up 5% per year too. The key assumption is that the stock price is fixed as multiple of the dividend. If you like to think in terms of P/E ratios, it is the equivalent to assuming that 5% earnings growth and a fixed P/E multiple must push the stock price up 5% per year. At the end of five years, our 3% dividend yield naturally gives us a 3% return ($19.14 if the dividends are reinvested). And the growth in dividends has pushed the stock price to $127.63, which gives us an additional 5% return. Together, we get a total return of 8%. That's the idea behind the dividendbased approach: the dividend yield (%) plus the expected growth in dividends (%) equals the expected total return (%). In formulaic terms, it is just a reworking of the Gordon Growth Model, which says that the fair price of a stock (P) is a function of the dividend per share (D), growth in the dividend (g) and the required or expected rate of return (k): EarningsBased Approach Here is the math that gets you the earningsbased approach: Whereas the dividendbased approach explicitly adds a growth factor, growth is implicit to the earnings model. It assumes the P/E multiple already impounds future growth. For example, if a company has a 4% earnings yield but doesn't pay dividends, then the model assumes the earnings are profitably reinvested at 4%. Even experts disagree here. Some "rev up" the earnings model on the idea that, at higher P/E multiples, companies can use highpriced equity to make progressively more profitable investments. Arnott and Bernstein  authors of perhaps the definitive study  prefer the dividend approach precisely for the opposite reason. They show that, as companies grow, the retained earnings they often opt to reinvest result in only subpar returns  in other words, the retained earnings should have instead been distributed as dividends. 
Handle with Care
Let's remember that the equity premium refers to a longterm estimate for the entire market of publiclytraded stocks. Lately several studies have cautioned that we should expect a fairly conservative premium in the future.
There are two reasons why academic studies, regardless of when they are conducted, are certain to produce low equity risk premiums.
The first is that they make an assumption that the market is correctly valued. In both the dividendbased approach and earningsbased approach, the dividend yield and earnings yield have reciprocal valuation multiples:
Both models assume that the valuation multiples  the pricetodividend and P/E ratio  are correct in the present and will not change going forward. This is understandable, for what else can these models do? It is notoriously difficult to predict an expansion or contraction of the market's valuation multiple. The earnings model might forecast 4% based on a P/E ratio of 25. And earnings may grow at 4%, but if the P/E multiple expands to, say, 30 in the next year, then the total market return will be 25%, where multiple expansion alone contributes 20%! (30/25 1 = +20%)
The second reason low equity premiums tend to characterize academic estimates is that the total market growth is limited over the longterm. You'll recall that we have a factor for dividend growth in the dividendbased approach. Academic studies assume that dividend growth for the overall market  and, for that matter, earnings or EPS growth  cannot exceed the total economy's growth over the long term. If the economy  as measured by gross domestic product (GDP) or national income  grows at 4%, then studies assume that markets cannot collectively outpace this growth rate. Therefore, if you start with an assumption that the market's current valuation is approximately correct and you set the economy's growth as a limit on longterm dividend growth (or earnings or earnings per share growth), a real equity premium of 4 or 5% is pretty much impossible to exceed.
Conclusion
Now that we have explored the risk premium models and their challenges, it is time to look at them with actual data. The first step is to find a reasonable range of expected equity returns; step two is to deduct a riskfree rate of return and; and step three is to try to arrive at a reasonable equity risk premium.

Investing
Build a Retirement Portfolio for a Different World
When it comes to retirement rules of thumb, the financial industry is experiencing new guidelines and the new rules for navigating retirement. 
Investing
Automating Your 401(k) is Easier Than You Think
If you like automation, you should check out these features that many 401(k) plans offer. 
Trading Strategies
Only Take a Trade If It Passes This 5Step Test
Not every moment is a good trading opportunity. Put each trade through this fivestep test, so you're trading only at the best profit potential times. 
Mutual Funds & ETFs
ETF Analysis: United States 12 Month Oil
Find out more information about the United States 12 Month Oil ETF, and explore detailed analysis of the characteristics, suitability and recommendations of it. 
Mutual Funds & ETFs
ETF Analysis: ProShares Ultra Nasdaq Biotechnology
Find out information about the ProShares Ultra Nasdaq Biotechnology exchangetraded fund, and learn detailed analysis of its characteristics and suitability. 
Fundamental Analysis
Examining Mexico's TrillionDollar GDP
Examining the gross domestic product growth and composition of Mexico, the second largest economy in Latin America 
Mutual Funds & ETFs
ETF Analysis: iShares Floating Rate Bond
Explore detailed analysis and information of the iShares Floating Rate Bond ETF, and learn how to use this ETF as a defense against rising interest rates. 
Mutual Funds & ETFs
Top 5 Japan Mutual Funds
Discover five of the most popular and bestperforming mutual funds offering investors direct exposure to equities of Japanese companies. 
Fundamental Analysis
What Causes Inflation in the United States
Inflation is the main catalyst behind U.S monetary policy. But what causes this phenomenon of sustained rising prices? Read on to find out. 
Mutual Funds & ETFs
ETF Analysis: PowerShares DB Commodity Tracking
Find out about the PowerShares DB Commodity Tracking ETF, and explore a detailed analysis of the fund that tracks 14 distinct commodities using futures contracts.

Cost Accounting
A type of accounting process that aims to capture a company's ... 
ZeroSum Game
A situation in which one person’s gain is equivalent to another’s ... 
Supply
A fundamental economic concept that describes the total amount ... 
PrincipalAgent Problem
The principalagent problem develops when a principal creates ... 
ExchangeTraded Fund (ETF)
A security that tracks an index, a commodity or a basket of assets ... 
Discount Bond
A bond that is issued for less than its par (or face) value, ...

What is the difference between market risk premium and equity risk premium?
The only meaningful difference between marketrisk premium and equityrisk premium is scope. Both terms refer to the same ... Read Full Answer >> 
Is my IRA/Roth IRA FDICInsured?
The Federal Deposit Insurance Corporation, or FDIC, is a governmentrun agency that provides protection against losses if ... Read Full Answer >> 
When does the fixed charge coverage ratio suggest that a company should stop borrowing ...
Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >> 
What does a high turnover ratio signify for an investment fund?
If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a oneyear period. ... Read Full Answer >> 
What is the utility function and how is it calculated?
In economics, utility function is an important concept that measures preferences over a set of goods and services. Utility ... Read Full Answer >> 
Does index trading increase market vulnerability?
The rise of index trading may increase the overall vulnerability of the stock market due to increased correlations between ... Read Full Answer >>