The U.S. equity risk premium (ERP) was lowered by Kroll’s valuation advisory team recently to 5.5% from 6.0%, where it had stood since October 2022. While that doesn’t sound like big news, it is worthy of acknowledgement.
One, Kroll’s recommendation signals the U.S. economy may be entering a period of less uncertainty, when inflation, interest rates, and economic growth will be more predictable. Two, as an indicator of the price of risk in equity markets, it suggests investors are slightly less risk-averse and more willing to invest in equities relative to risk-free securities.
It can also be good news for M&A activity, as a high ERP can dampen buyers’ enthusiasm for deals.
For a CFO, a change in the ERP is essential because it’s a key input to determine the cost of equity and, through the capital asset pricing model (CAPM), generating the expected rate of return for a proposed asset or investment — not to mention other important valuation work.
Kroll had raised its ERP recommendation to 6% last October due to market uncertainty and volatility in the U.S. and then kept it there during the banking mini-crisis that threatened a repeat of 2008. The ERP remained 6% as Congress hit the federal government’s debt ceiling stalemate.
But with that political battle resolved on June 3, combined with lower inflation, a temporary pause in the Federal Reserve’s monetary tightening, and a lower chance of a U.S. recession, Kroll dropped the ERP half a percentage point on June 8.
“The economy's in a much better state than it was back [in October], said Carla Nunes, managing director of Kroll’s valuation group, and an expert in cost of capital, goodwill impairment, and cross-border valuations. “We have unemployment at a record-low level, and it seems like the Fed is sort of getting inflation under control,” Nunes told CFO.
In addition, “the spread between high yield and investment grade [corporate bonds] is pretty tight, which doesn't signal a lot of risk,” Nunes said.
But there’s still plenty of uncertainty, preventing Kroll from dropping its ERP recommendation to its pre-pandemic 5%. When will the Fed be done raising rates? Are two more rate hikes a foregone conclusion? “And obviously, the higher interest rates cause potentially more stress to the system; some businesses will probably default,” she said.
Risk Perception Inputs
The early approach to estimating the equity risk premium, developed by Roger Ibbotson, was to take the estimated real returns on stocks and subtract the real return on safe bonds. Now, Kroll factors in risk perceptions in the market and other qualitative and quantitative inputs:
Financial Markets
- U.S. equity markets
- Implied equity market volatility
- Corporate credit spreads
- Implied ERP model
- Default spread model
- U.S. equity market uncertainty index
Economic Indicators
- Historical and projected real GDP growth
- Unemployment
- Consumer sentiment
- Business confidence
- Sovereign credit ratings
- Economic policy uncertainty (EPU) index
Aswath Damodaran, finance professor at NYU’s Stern School of Business (often called the “dean” of valuation) recently lowed his implied ERP for the S&P 500, which is based partly on long-term earnings growth, to 5%. (See chart.)
Despite lower ERPs, the base cost of equity (ERP plus the risk-free rate) resembles 2008 levels, because the risk-free rate is 3.5% (using the spot yield on 20-year U.S. Treasuries, as Kroll does.) That still means a relatively high cost of capital for companies.
“A CFO wants to use something empirically derived and not an ad hoc adjustment.”
Carla Nunes
Managing Director, Kroll
While some companies have strayed from using the CAPM (and therefore the equity risk premium) for analyzing capital projects and instead use a hurdle rate, measurements like the ERP and cost of capital are still an important tool for CFOs, said Nunes, even those who don’t spend the bulk of their time inside spreadsheets.
CFOs and controllers need to be comfortable with the discount rate used in a goodwill impairment analysis, for example, for financial reporting and auditor scrutiny, said Nunes. And a CFO needs to be able to answer a board of directors when they ask why an investment is underperforming, said Nunes, and if the discount rate is pricing in enough of the risk (and the cash flow assumptions are realistic).
When incorporating such risks into a discount rate, “[a CFO] wants to use something empirically derived and not an ad hoc adjustment,” said Nunes.