return equaled 69.1 percent. This translates to an annual rate of 5.4 percent.

The range of
excess returns falls between 5.4 percent and 6.1 percent. Alternatively, researchers have
used simulation to show that an estimator proposed by Marshall Blume best adjusts for
problems caused by estimation error and autocorrelation of returns:12 R=T N T 1
RA+N1 T 1 RG where T=number of historical observations in the sample N=forecast
period being discountedR A=arithmetic average of the historical sampleR G=geometric
average of the historical sample Blumes estimator depends on the length of time for
which you plan to discount. The rst years cash ow should be discounted using the
arithmetic average(T=110,N=1),whereasthe10thyearscashowshoulddiscounted based
on a return constructed with a 91.7 percent weighting on the arithmetic average and an
8.3 percent weighting on the long-term geometric average
(T=110,N=10).InthelastcolumnofExhibit11.5,wereportBlumesestimate for the market
risk premium by the length of the forecast window. The bottom line? No matter how we
annualize excess returns, group the aggregation windows, or simulate estimators, the
excess return on U.S. stocks over government bonds generally falls between 5 and 6
percent.

In the previous section, Lewellen and others regressed market returns on the dividend-to-

price ratio. Using a simple regression, however, ignores

valuableinformationandoversimpliesafewmarketrealities.First,thedividendtopriceyielditselfdependsontheexpectedgrowthindividends,whichsimple regressions ignore
(the regressions intercept is determined by the data).
Second,dividendsareonlyoneformofcorporatepayout.Companiescanusefree cash ow to
repurchase shares or hold excess cash for signicant periods of time; consider Microsoft,
which accumulated more than $50 billion in liquid securities before paying its rst
dividend. Using the principles of discounted cash ow and estimates of growth, various
authors have attempted to reverse engineer the market risk premium. Two studies used
analyst forecasts to estimate growth,18 but many argue that analyst forecasts focus on the
short term and are severely upward-biased. In a 2001 working paper, Fama and French
use long-term dividend growth rates as a proxy for future growth, but they focus on
dividend yields, not on available cash ow.19 Alternatively, our own research has focused
on all cash
17A. Goyal and I. Welch, Predicting the Equity Premium with Dividend Ratios,
Management Science

percent, are too high for valuation purposes because they compare the market risk
premium versus short-term bonds, use only 75 years of data, and are biased by the
historical strength of the U.S. market. Even the recent severe nancial crisis has not
caused a dramatic rise in
themarketriskpremium.BetweenOctober2007andMarch2009,theS&P500
indexdroppedbymorethan50percentastheglobalnancialcrisisdominated the news. Many
of our clients questioned whether a lower appetite for risk among investors caused the
drop in value, implying a dramatic rise in the market risk premium and consequently the
cost of capital. The data say no.
Usingthekeyvaluedriverformulaandtheparametersoutlinedearlier,thereal
costofequityroseonlyonepercentagepointduringthecrisis,from6.8percent
in2007to7.8percentin2008.Thisrisematchestheincreaseintheriskpremium reported by chief
nancial ofcers (CFOs) to the Duke CFO survey.22 So why the large drop in equity
prices? The global nancial crisis leaked into the real economy, and corporate earnings
suffered as a result. Based on these results, we do not believe companies should increase
the risk premium embedded in their internal hurdle rates.
Estimating beta According to the CAPM, a stocks expected return is driven
bybeta,whichmeasureshowmuchthestockandentiremarketmovetogether. Since beta cannot
be observed directly, you must estimate its value. To do this, begin by measuring a raw
beta using regression, and then improve the estimate by using industry comparables and
smoothing techniques. Even with a robust estimation process, judgment is still required.
When necessary, consider how the industry is likely to move with the economy, in order
to bound your results. Start with the