Equity Risk Premium (ERP) Model
Latest Update: May 27, 2019
Updated by: John Moschella, CFA, CPA
Model Summary: This model uses the Fed Funds rate, 10-year U.S. Treasury rate, implied volatility, equity market returns, and the Constant Sharpe Approach, to estimate the Equity Risk Premium (ERP). The ERP and the Capital Asset Pricing Model (CAPM) are used together to calculate the required return on equity for our DCF-based share valuation models.
What changed in the latest version: The model has been updated to include the latest market data for interest rates, volatility, and equity returns through May 24, 2019, as well as the FOMC Statement from the May 1, 2019 Fed meeting, and the April/May-2019 Market Participant Survey Results published by the Federal Reserve Bank of New York. Based on the results of the latest Fed Statement, comments from the FOMC Chairman, and Market participant survey, I have removed the last 25 basis point increase that the previous version of the model included in the 2020 Fed Funds rate projection. The model now projects a flat 2.4% Fed Funds rate through the end of 2020 (which is the midpoint of the Fed's 2.25% to 2.50% range.
In addition to the Fed Funds target updates I have also performed data maintenance to include the latest available equity returns, volatility, and the spread between the 10-year U.S. Treasury Security and the Fed Funds Rate. In my spread forecast I have estimated a reversion towards the longer-term average of 1.64%, with the spread moving from 0.25% on average in 1Q2019 to 1.30% by the end of 2020.
Latest ERP Estimate for 2Q2019: 5.3% versus the previous estimate of 5.4%. The model-based ERP forecast remains below the historic average of 6.0%.
Estimates used in all of our Premium company earnings models for the second calendar quarter earnings season include the following:
Disagree with this projection? We maintain "base-case" models for our community members to download and input their own forecast. There are many factors you can change in the ERP model including: the timing of Fed rate changes, the spread in the 10-year Treasury vs the Fed Funds rate, volatility assumptions, and equity market return projections. Try it today, and share your forecast with the Gutenberg Community.
Planned ERP Model updates:
Models From Our Community
Last Updated: February 22, 2017
2017 ERP Estimate: 5.0%
Model Up Votes-to-Total Votes: 70%
Summary of Model Estimates: In general I have a bullish outlook on the market for 2017 based on the following:
Gutenberg Modeling Guide
New to earnings modeling?
Our modeling guide demonstrates step-by-step how to create a financial model, similar to the models maintained by Wall Street Analysts.