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› Oct 2011: Equity Risk Premium for India

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Equity Risk Premium for India

Last revised 28-Oct-2011. Send comments to galatime@gmail.com.

This essay is a compilation of existing estimates for the Equity Risk Premium (ERP) in India, and a brief recommendation on a practical range for ERP-based valuation & decision making in India. This is neither academic research nor primary market research.

Background

ERP is the excess return that the overall stock market provides over a risk-free rate, in order to compensate investors for taking on the relatively higher risk. ERP is also known as Market Risk Premium.

ERP is widely used:

  1. In corporate finance, to determine the costs of equity and capital for firms, optimize debt:equity ratios, and decide upon investment, buyback policies.
  2. In corporate valuation, as one of the key inputs that determine the present value of future cash flows.

ERP Calculation

ERP can be calculated using several alternative methods:

  • Empirically, as a difference between historical market returns and historical risk-free rates
  • Forward-looking estimates, as a function of expected macro-economic factors
  • Survey-based estimates, by querying a diverse set of market participants

Regardless of the method used, ERP estimates are never straightforward; assumptions and judgment play a large role in the calculations. The usage of ERP, the methods used to calculate ERP, even the concept of ERP itself, remain controversial.

ERP for Global Markets

Across the world, there have been many attempts at estimating ERP - by geography, by time period, by asset class, etc. What follows is a summary of popular research on this topic.

1. Aswath Damodaran

Prof. Damodaran's (very popular) site has tons of data and analyses on the ERP. His 2011 paper - ERP: Determinants, Estimation and Implications - takes into account the huge changes in ERP during & after the 2008 crisis. In his words:

The ERP is neither a mathematical number nor is it a statistical number. Instead, it is a reflection of what investors are feeling in their gut.
...
ERP is best determined using surveys, combined with forward-looking estimates, revised frequently.
...
ERPs for emerging markets have been: a) tough to estimate given lack of data, and b) in rapid decline.
2. Elroy Dimson, Paul Marsh and Mike Staunton

This trio authored Triumph of the Optimists - the definitive guide to long-term equity market returns across the world. Here is what they have to say on ERP in their paper Global Evidence on the Equity Risk Premium.

Since the middle of the last century, equity cash flows have almost certainly exceeded expectations. Stock markets have therefore risen for reasons that are unlikely to be repeated. This means that when developing forecasts for the future, investors and managers should adjust historical risk premiums downward for the impact of these factors.
...
This suggests that a plausible, forward-looking risk premium for the world’s major markets would be on the order of 3% on a geometric mean basis, while the corresponding arithmetic mean risk premium would be around 5%.

[See also this McKinsey paper on stable ERPs of 3.5% to 4% for US & UK. For a very detailed analysis of various ERP calculation methods and estimates for developed markets, see Equity Risk Premium: Expectations Great and Small.]

3. ERP Mega-Survey

This is an interesting paper published earlier this year - Market Risk Premium Used in 56 Countries in 2011: A Survey with 6,014 Answers. As the authors note:

Most previous surveys have been interested in the Expected MRP, but this survey asks about the Required MRP.
...
Many market participants (equity investors, investment banks, analysts, companies…) do not use standard theory (such as a standard representative consumer asset pricing model…) for determining their Required Equity Premium, but rather, they use historical data and advice from textbooks and finance professors.
...
Consequently, ex-ante equity premia have been high, market prices have been consistently undervalued, and the ex-post risk premia has been also high.

Look at the survey finding below - depending on whom you talk to (professors, analysts or companies), the ERP estimates vary widely, and not always consistently.

4. Falkenstein: ERP = 0.

Eric Falkenstein wonders Is the Equity Risk Premium Actually Zero?.

Consider the following annualized adjustments that mainstream economists apply piecemeal, though when considered in total take the current ERP estimate of 3% well below zero:
  • Geometric vs. Arithmetic averaging: 2% (See Dimson, Marsh, and Staunton).
  • Survivorship Bias/Peso Problems: 3% (see Rietz, Jorion and Goetzmann, Barro).
  • Taxes: 3% (see Gannon and Blum, 2006).
  • Adverse market Timing: 3% (See Dichev, 2005).
  • Transaction Costs:

Admittedly, this sounds extreme and flies in the face of the traditional notion: high-risk = high-return.

5. ERP during crises

The 2007-? financial crisis has brought us some spectacular blowups in credit spreads and volatility. This in turn has had a significant impact on ERP, as explained by Graham & Harvey in The Equity Risk Premium amid a Global Financial Crisis.

We provide a direct measure of 10-year market returns based on a multi-year survey of CFOs. Importantly, we have a ‘measure’ of expectations.
...
We offer evidence that the risk premium is higher during recessions ... Given the current global economic crisis, the risk premium has hit a record high for our 9 years of surveys.
...
We find that both the implied volatility on the S&P index as well as a commonly used measure of credit spreads are highly correlated with the risk premium.

Summary: ERPs across the world have typically been over-estimated, especially in developed markets. Even for emerging markets, ERPs have been steadily trending lower, despite the relatively higher volatility. Historical ERP estimates must be adjusted for macro-economic expectations, credit conditions, investor sentiment and sheer gut feeling.

ERP for India

The table below lists various studies on the ERP for India.

No. Source ERP estimate
1. Aswath Damodaran, 2000 - 2011.
Annual ERP estimates
2000: 8.5%
2001: 8.5%
2002: 10.5%
2003: 7.0%
2004: 9.3%
2005: 8.8%
2006: 8.6%
2007: 8.5%
2002: 11.0%
2009: 9.0%
2010: 8.6%
2011: 8.6%
2. Goldman Sachs, 2011.
Linking GDP Growth and Equity Returns
[Thanks to @lukkha for the link.]
4.9%
(uses real instead of nominal data)
3. ISES Survey, 2011.
Market Risk Premium Used in 56 Countries in 2011
7% - 10%
4. VC Circle, 2010.
What Is the Real Cost of Equity in India?
7.25%
5. Morgan Stanley, 2010.
India's Coming Growth Acceleration
6.0%
6. Banco de Portugal, Economic Bulletin, 2008.
Equity Risk Premia Across Major International Markets
5.9%
(1995-2008 average)
7. Jayant Varma & Samir Barua, 2006.
First Cut Estimate of the Equity Risk Premium in India
8.75% (geometric)
12.5% (arithmetic)
8. JM Morgan Stanley, 2006.
India's equity risk premium high
6%
9. Rajneesh Mehra, 2006.
The Equity Premium in India
9.7% - 11.3%
10. Ajay Shah, 2005.
Returns on equity index portfolios in India
Historical (1979-2004): 10%
Forward estimate (2005 -): 8%

Note that each of the above studies differs from the others in methodology, data sources, time periods, nuances of ERP estimates, etc.

Conclusion: An Appropriate Forward-looking ERP range for India

As Damodaran points out, where you stand on the ERP issue depends on where you sit. Macro-strategists or market traders are bound to look at ERP from a different perspective than a value investor like Buffett or a corporate CFO who is in charge of funding long-term projects.

For most long-term (5+ year) corporate finance purposes, I think the best estimate is a long run average of ERP for India, adjusted for 3 factors:

  1. Steady decline in ERP as the Indian economy matures
  2. Occasional blow-ups in ERP during periods of global/local financial crises
  3. The impact of taxes, transaction costs and volatility (arithmetic vs. geometric mean)

The historical ERP for India is in the range of 9% - 10%. The secular decline in the ERP will probably overshadow an occasional crisis-driven spike; especially so from a CFO (versus trader/investor) point of view. Taxes, costs and the use of (lower than arithmetic) geometric mean will likely further lower the ERP estimate.

In conclusion, a reasonable educated guess estimate for forward-looking ERP for India is 8% - 8.5%.