Equity Risk Premium (ERP) Model
Latest Update: April 3, 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 March 31, 2019, as well as the FOMC Statement and Projection Material from the March 20, 2019 Fed meeting. As a result of this latest Fed meeting, we have removed two 25 basis point increases from our Fed Funds rate forecast which now reflects the current FOMC projection material forecast of no increases in 2019 and one increase in 2020. The Fed Funds target range remains constant at 2.25% to 2.50%. For 2020 we have moved our 25-basis point increase from the second quarter to the first quarter of 2020.
In addition to the Fed Funds target updates we have also performed data maintenance to include the latest available equity returns, volatility, and spread between the 10-year U.S. Treasury security and the Fed Funds rate. In our spread forecast we move from ~0.2% spread to ~0.9% by the end of 2020, which includes an estimate of some impact from the balance sheet normalization program.
Latest ERP Estimate for 1Q2019: 5.4% versus the previous estimate of 5.5%. The slight decrease from the last update reflects the impact of lower interest rates (spread) and lower volatility. The ERP remains below the historic average of 6.0%.
Estimates used in Premium models for the first quarter earnings season:
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.