Risk Premia: What About the "Supply Side" Method?

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Permalink Reply by Greg on August 10, 2010 at 9:21am

Supply Side - Gives a better indication of the current market.
Also the premia aligns better when used in the future cash flow model

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Permalink Reply by Sachidanand (Sacha) Singh on August 10, 2010 at 2:43pm

Typically equity risk premium (ERP) is determined on teh basis historical returns. What excess return the equities have given over Rf in past. Supply side method, roughly speaking, estimates the returns expected in future and from that deducts Rf of the day.

It is favoured by many. Unless the analyst is very objective, she / he is likely to be swayed by the current market mood which may be just a passing fad.

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Permalink Reply by Chuck Smith on August 10, 2010 at 5:01pm

Hello Tonya,
Morningstar (formerly Ibbotson) publishes two versions of the equity risk premia: Historical ERP and Supply-Side ERP. They explain both in good detail in their publications, but I will summarize here.
Both measures begin with the same calculation...taking the equity market return premium experienced over history since 1926. The Historical stops there. The Supply-Side calculation makes another adjustment...they analyze how the market P/E has expanded in recent decades and removes this bias. The theory is that the P/E expansion that has occurred since 1986 is not sustainable, so removing it makes the ERP a better indicator of what to expect in the future.
-Chuck Smith

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Permalink Reply by Tonya Brown on August 12, 2010 at 11:29am

Got it. I'm an MSF student and learning all this right now.


My thoughts are that supply-side can be quite subjective, as you said, and can be biased by the "mood of the day". Historical is much more objective (which I personally prefer), but the question of course is whether or not history will repeat itself. So I see pros and cons for both. I would definitely prefer historical, but with an adjustment - which would make it supply-side then!

I think anytime you start "tweaking" or adjusting data, the integrity can be compromised, but I've found that it is necessary in finance!

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Permalink Reply by Shafi on September 6, 2010 at 3:13pm

I think this is a tricky issue. Given the current level of ICT development and the changing space of business competition brought by it coupled with dirty business models sustained for long time before global financial crisis, the history may not be a good judge of what will happen in the future. I am wondering if you were valuing wall street companies currently on the verge of collapsing, or have actually collapsed on the aftermath of global financial crisis using such kind of a model (removing the bias effects of a past decade), it is likely for them to be projected as profitable company in the future while the reality may be that they will not turn around or have alredy been bankrupted! Any counter-comment from this will be highly appreciated.

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