Question

Hello all. Can anyone please explain how the "smoothed over" ERP is calculated relative to the "T12 mos" ERP? And which is more appropriate to use in estimating the cost of equity? Thank you!

Answer 1

ERP that you are referring to I believe is the implied ERP. it is computed as dividends and buybacks divided by cost of equity minus growth of dividends and buybacks as pedicted by analysts. cost of equity is computed using CAPm. since the risk free rare is known and beta is 1 for the index then risk premium can be computed and it is what the market is using to get the current index level. If dividends and buybacks are volatile then it makes sense to take an average over the last 3 or 5 years to get an average dividends and buybacks over the most recent 3 or 5 years. Consequently the ERP that we compute reflects the cash paid by firms that consititute the index in the last 3 or 5 years. On the other hand , th etrailing 12 months ERP is computed from what the firms paid in the last 4 quarters. Now the question that I have is to why Damodaran is reporting both of them and when to use one of them and not the other. I believe that the trailing 12 months makes more sense if the cash flow is stable and the normalized makes more sense if the cash flow is volatile