The task of estimating a company’s expected return typically involves an initial estimate of the market’s expected return. This, in turn, is usually based on summary statistics about risk premiums drawn from historical average returns. The approach appears simple, but the underlying complexities may trip up unwary analysts.
The authors demonstrate how choice of measurement period, averaging method, portfolio weighting and risk-free rate can cause the equity risk premium to vary from 0.9 to 24.9 per cent. Over the 1926-80 period, for example, the arithmetic mean annual return on an equally weighted portfolio was 17.1 per cent; the geometric mean annual return on a corresponding value-weighted portfolio was 9.1 per cent. Furthermore, differences in historical returns between industries, and company size effects within industries, are also substantial.