Ibbotson’s Answer
An international consulting firm provides a solution for calculating the equity
risk premium for international markets.
One of the most important elements in any
business valuation is the equity risk premium.
There are many variations to estimating the
equity risk premium, consequently, the ulti-
mate value of a business will depend on the
chosen approach.
While the underlying assumptions for deter-
mining the appropriate method of calculation are
still widely debated, the equity risk premium pre-
sented by Ibbotson Associates (Ibbotson) is one of
the most frequently cited. This article explores
calculation assumptions behind the Ibbotson eq-
uity risk premium, as well as its applications to
international markets.
Use of the Equity Risk Premium
The equity risk premium is a critical parame-
ter for a variety of valuation models. The buildup
method, capital asset pricing model (CAPM), and
Fama-French 3-factor model all use the equity
risk premium in determining an appropriate cost of
equity.
The buildup method sums various risk premia,
including the equity risk premium and a risk-free
rate. The CAPM is similar to the buildup method,
except the equity risk premium is multiplied by
the systematic risk, or beta, of the entity before the
risk-free rate (and possibly a size premium) is
added. The Fama-French 3-factor model is an ex-
tension of the CAPM, with two factors in addition
to the market that are expected to influence stock
movements. The Fama-French model includes a
factor for size, financial distress, and market risk
(equity risk premium).
Numerous international cost of equity models
utilize the equity risk premium from one country
as a base for calculations in another. The interna-
tional CAPM and relative standard deviation mod-
els, along with the globally nested CAPM and
country spread models, developed by Andrew
Clare and Paul Kaplan, are examples of models
that use the equity risk premium in similar form.
Definition and Calculation
The expected equity risk premium is defined
as “the additional return an investor expects to
Michael W. Barad, Ibbotson Associates
receive, to compensate for additional risk associ-
ated with investing in equities as opposed to risk-
less assets.”
It is important to note that the equity risk pre-
mium used in business valuation is a forward-
looking concept. In business valuation, the entity
is typically viewed as a going concern, meaning
that operations are expected to continue indefi-
nitely.
Calculating the equity risk premium is rela-
tively straightforward, once the assumptions have
been determined. The basic equity risk premium
presented by Ibbotson takes the arithmetic mean
total return of stocks and subtracts the arithmetic
mean income return of bonds.
Simply stated, we are interested in the excess
return of stocks over bonds.
Benchmark Selection
Ibbotson uses the S&P 500 as the market
benchmark, from which the income return on the
appropriate horizon Treasury bond is subtracted,
in calculating the equity risk premium for the
United States.
Since most business valuations are performed
as going concerns, a long-horizon (20-year) bond
is an appropriate representation of the riskless as-
set in calculation of the equity risk premium.
Broader market benchmarks, such as the New
York Stock Exchange weighted index, may be
used as well.
Ibbotson has chosen the S&P 500 for its
broad industry and equity capitalization coverage
as well as its wide acceptance as a market proxy.
Long-term bonds of different maturity, such as 10-
year and 30-year bonds, are also acceptable alter-
natives to proxy the riskless asset.
While changes in the market benchmark can
alter the equity risk premium between 0 and 100
basis points, changes in the long-term horizons on
the riskless asset benchmark amount to small dif-
ferences.
 Exhibit 1

Annual U.S. Equity Risk Premium 1926-2000

60

50

40

30

20

10

-10

-20

-30

-40

-50
1935 1945 1955 1965 1975 1985 2000
Year-end

The same principle applies to benchmark se-
lection when calculating the equity risk premium
for countries other than the United States. In Can-
ada, for example, the Toronto Stock Exchange
(TSE) 300 is an acceptable stock market bench-
mark. While availability of data is always an issue,
Morgan Stanley Capital International (MSCI)
provides a number of equity market indices for
many different countries that can work well in the
equity risk premium calculation. Finding data on
the riskless asset also can be difficult. The Inter-
national Monetary Fund’s “International Finan-
cial Statistics” data provides yield series for a va-
riety of countries that can be converted to income
return series.
Any series used in the analysis should contain
quality financial data from a reliable source and
must have a significant history of data to draw
from.
Appropriate Time Period
While some claim that surveys and forecasts
are appropriate for determining the equity risk
premium going forward, most believe that the use
of an appropriate historical time period is the best
estimate of future performance. For those who
agree on the use of historical data, the argument
then turns toward the appropriate length of time
from which to take the data.
Serial correlation is one test that can be ap-
plied to verify whether prior year’s returns can aid
in predicting subsequent year’s performance. Val-
ues range from “–1” to “1,” with zero signifying
complete randomness (no predictability) and the
extremes representing a perfect negative or posi-
tive relationship (strong predictability), respec-
tively.
Serial correlation for the annual excess returns
of the equity risk premium in the U.S., Canada,
Japan, Germany, and many other countries are
close to zero. This means that the equity risk pre-
mium is random or unpredictable if based on the
prior year’s performance.
Therefore, the most recent time period is no
better or worse at predicting next year’s equity
risk premium than has been any other time in the
past. For these reasons, the appropriate historical
period of data to use is the longest period of qual-
ity data available. Exhibit 1 illustrates the random
character of the equity risk premium on an annual
basis.
While data is available as far back as the
1800s for the U.S., Ibbotson has determined that
the highest quality data extends back to 1926, as
has been provided by the Center for Research in
Security Prices (CRSP). Ibbotson uses data back International Analysis
to 1919 for the UK, 1936 for Canada, and as far Once the assumptions for calculation of the
back as possible for other countries. equity risk premium are agreed upon, the premium
can be calculated for any country with enough
Total Return vs. Income Return
quality data. Exhibit 2 compares the equity risk
Calculating the Ibbotson equity risk premium
premium across different countries over a com-
considers the “total return” of stocks, minus the
mon time period of 1970-2000.
income return of bonds.
Data has been presented in both U.S. dollars
Total return is used for stocks because it rep-
and in each country’s local currency. This graph
resents the return an investor will actually experi-
uses 1970 as a common starting point across
ence from an equity investment. Price return
countries. Since many of these countries have
(capital appreciation) plus income return combine
more data available than presented here, each
to form an asset’s total return. In forming an eq-
country should be evaluated individually to deter-
uity risk premium, total return is not appropriate
mine the appropriate historical range to calculate
for measurement of the riskless asset because total
its equity risk premium.
returns include price return, which fluctuates in-
While this chart presents data for only six
versely with interest rates.
countries, Ibbotson calculates the equity risk pre-
There is much uncertainty surrounding fluc-
mium for sixteen developed nations.
tuation of a bond’s (positive or negative) capital
An issue concerning international investors
appreciation. The income return from a bond is the
has been the idea that the world is becoming a
appropriate measure of the truly riskless portion of
global market. Specifically, equity markets
the bond and should be used as the measure of the
worldwide are reacting to each other with higher
riskless asset in the equity risk premium calcula-
correlation than in the past, thereby lessening the
tion.
effects of diversification.
Arithmetic vs. Geometric Means One interesting example can be found by ex-
An equity risk premium that is to be used in amining the equity risk premium of the United
discounting future cash flows should be calculated Kingdom and that of the United States over the
using arithmetic computations. The arithmetic past ten years. Graph 3 shows the similarity of
mean takes into account uncertainty of period-to- movement in the equity risk premium of both na-
period returns. tions.
The greater the standard deviation for a return
Summary
series, the higher the arithmetic mean will be
While there is still much debate about which
compared to the geometric mean. This type of pe-
methods to use when calculating the equity risk
riod-to-period riskiness must be accounted for
premium, it is important to understand the under-
when forecasting.
lying assumptions Ibbotson has made.
Ibbotson does provide geometric means and
The first is that the appropriate historical time
geometric calculations of the equity risk premium,
period to measure the equity risk premium from is
but these are intended for audiences interested in
the longest period over which quality financial
purely historical analysis. The compound average
data exists. Since the equity risk premium in one
is appropriate for analyzing past returns, while the
year cannot predict returns in the next, choosing
arithmetic average is appropriate for forecasting.
Exhibit 2

Per Country Comparison of

Equity Risk Premium 1970-2000

14.00%
Equity Risk Premium

12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
Australia U.S. U.K. Germany Belgium Japan

U.S. Dollar Local Currency

Exhibit 3

UK vs. U.S. Annual Equity Risk Premium (in Dollars)

40%
U.K. U.S.
30%
Equity Risk Premium

20%

10%

0%
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000
-10%

-20%

only recent data is not the most prudent choice as

it can overemphasize unusual events.
Further, the income return is the correct
measure of the riskless asset as it is the portion of
a bond’s return guaranteed by the government.
Finally, when aggregating the total return on
stocks and the income return on bonds, arithmetic
means are appropriate for creating a forward
looking equity risk premium while geometric
means are used in purely historical analysis.
The assumptions set forth here can be applied
to a wide range of international markets, subject to
data availability. While there is no doubt that the
debate over calculation of the equity risk premium
will continue, this article presents a fairly simple
method for which data on many countries can be
obtained and applied.

Michael Barad is Manager, Valuation & Legal

Services at Chicago-based Ibbotson Associates.
Readers wanting to learn more about the equity
risk premium and Ibbotson’s methodolgy can
contact him by telephone at (312) 616-1620 or via
e-mail at mbarad@ibbotson.com.