What is a Reasonable Equity Risk Premium?

The equity risk premium is a very simple concept: it is simply the difference between risky equity returns and riskless asset returns. What isn’t so easy is predicting what the equity risk premium will be in the future.

Just because the exercise isn’t easy doesn’t mean you should ignore it. Too much depends on it. The dominant factor that should drive the basic stock/bond split asset allocation decision is the additional return that you expect from stocks over approximately risk-free assets.

To estimate forward-looking equity risk premiums. you must first estimate forward-looking equity returns. That is, what annualized return do you expect the total stock market to deliver over the long term?

Here, it is critical that you not simply fall back on historical returns, and hope that the past will repeat itself. To estimate future equity returns, you must break them down into their constituent components.

Principal #1: In the very long term, total market equity returns = current dividend yields + dividend growth rate

Future equity returns, over the very long term, will be made up of two very simple components: current dividend yields plus the expected very-long-term dividend growth rate. See William Bernstein, The Expected Return One-Step (2001) ([L]ong-term equity returns are closely approximated by the sum of dividend/earnings growth and the dividend rate); see also Credit Suisse Global Investment Returns Yearbook 2009 * (For the seriously long-term investor, the value of a portfolio corresponds closely to the present value of dividends.).

Principal #2: In the very long term, dividends cannot grow faster than the economy

You can be sure that the very-long-term dividend growth rate cannot exceed the very-long-term economic growth rate. As William Bernstein* wrote in “The Returns Fairy…Explained”.

“It is impossible for long-term corporate growth to be higher than GDP growth

for this would entail corporate profits eventually growing larger than the economy itself.”

Principal #3: The Lag – in the long run, dividend growth lags economic growth

In fact, the very-long-term dividend growth rate is likely to lag the very-long-term economic growth rate. That is what has happened historically.

In Credit Suisse Global Investment Returns Yearbook 2009 *, Elroy Dimson, Paul Marsh, and Mike Staunton of the London Business School report their findings on a database of stock and bond returns for 17 countries over the 109-year span from 1900 to 2008. They found that real dividends rose by only 0.65%/year in a “world index” they constructed for the 17 countries. See page 8. This was more than 1% below global real economic growth over the same period (which was approximately 2%/year). See page 22. They report that in the United States, real dividends grew at an annualized rate of 1.2%/year between 1900 and 2008. See page 8. This is 2% below the 3.23% in annualized growth in real GDP that the U.S. experienced. Others, including Robert Arnott * and William Bernstein *, have also written about this “dilution” of earnings as it passes through to dividend growth.

Principal #4: Low payout ratios and larger stock repurchase programs portend (but don’t guarantee) less of a subsequent lag between economic and dividend growth

However, today the payout ratio (dividends/earnings) of the S&P 500 is well below historical norms.

Today’s lower-than-historical payout ratio may explain as much as 0.4% of that historic 2% lag between U.S. economic growth and U.S. dividend growth. That is, if the companies in the S&P 500 had issued about 50% of their earnings over the past 5 years as dividends, then the lag between economic growth and dividend growth between 1900 and 2008 would have only been about 1.6%.

Fortunately, today’s smaller payout ratio should portend even less of a future lag between economic growth and dividend growth. After all, companies that reinvest most of their earnings ought to grow faster than they would if they had distributed those earnings as dividends instead.

Today, companies are also using a larger share of their earnings to buy back stocks than they did in the past. Companies that use some of their earnings to buy back their stock may be able to afford to distribute more dividends/share in the future than they otherwise would. After all, stock buy-back programs result in fewer shares amongst which to distribute future dividends. So stock buy-back programs should also result in a higher dividend growth rate.

Lower payout ratios also give dividend yields more room to grow, so dividend yields may grow a little bit faster than they otherwise would.

In summary, there is a reasonable basis to expect less of a lag, in the U.S. and its stock market, between future economic and dividend growth.

The Formula (Part I):

So here’s one plausible formula for the future equity returns for the total stock market:

ER = DY + G — Lag — Fees

Where ER = equity returns, DY = dividend yield, G = long term expected real economic growth, Lag = the amount dividend growth in market indices is expected to lag overall economic growth, and Fees = expense ratio fees, loads (if any), transaction costs, and (if you entrust your investments to an advisor) assets-under-management fees.

(You can also incorporate estimated small & value premiums into the formula. For more information, see here ).

Dividend Yield Information:

So what are broad stock market dividend yields today? Surprisingly, it takes a lot more digging than it ought, to find that out. Do a search for index dividend yields, and you get a bunch of links to ETFs and mutual funds that screen stocks in favor of high dividend yields.

Russell Investments * provides one of the best resources Prospercuity has found for dividend yield information on different equity asset classes. Russell Investments – which developed a series of U.S. and global indices that many investors are familiar with (e.g. the Russell 2000 Index) – provides dividend yield information on each of its indices. For example, Russell reported the following dividend yields for the following indices as of June 30, 2009: