Estimating the Equity Premium

John Y. Campbell

NBER Working Paper No. 13423
Issued in September 2007
NBER Program(s):Asset Pricing, Monetary Economics

To estimate the equity premium, it is helpful to use finance theory: not the old-fashioned theory that efficient markets imply a constant equity premium, but theory that restricts the time-series behavior of valuation ratios, and that links the cross-section of stock prices to the level of the equity premium. Under plausible conditions, valuation ratios such as the dividend-price ratio should not have trends or explosive behavior. This fact can be used to strengthen the evidence for predictability in stock returns. Steady-state valuation models are also useful predictors of stock returns given the high degree of persistence in valuation ratios and the difficulty of estimating free parameters in regression models for stock returns. A steady-state approach suggests that the world geometric average equity premium was almost 4% at the end of March 2007, implying a world arithmetic average equity premium somewhat above 5%. Both valuation ratios and the cross-section of stock prices imply that the equity premium fell considerably in the late 20th Century, but has risen modestly in the early years of the 21st Century.

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Document Object Identifier (DOI): 10.3386/w13423

Published: John Y. Campbell, 2008. "Viewpoint: Estimating the equity premium," Canadian Journal of Economics, Canadian Economics Association, vol. 41(1), pages 1-21, February.

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