IESE Research Papers,
IESE Business School

Abstract: This paper is a review of the recommendations about the equity premium found in the main finance and valuation textbooks. We review several editions of books written by authors such as Brealey and Myers; Copeland, Koller and Murrin (McKinsey); Ross, Westerfield and Jaffe; Bodie, Kane and Marcus; Damodaran; Copeland and Weston; Van Horne; Bodie and Merton; Stowe et al.; Pratt; Penman; Bruner; Weston & Brigham; and Arzac. We highlight the confusing message the textbooks convey regarding the equity premium and how it changes. The main confusion arises from not distinguishing among the four concepts that the term "equity premium" designates: Historical equity premium (HEP), Expected equity premium, Required equity premium (REP) and Implied equity premium (IEP). Some confusion also arises from not recognizing that although the HEP is equal for all investors, the REP, the EEP and the IEP are different for different investors. A unique IEP requires assuming homogeneous expectations for expected growth (g), but there are several pairs (IEP, g) that satisfy current prices. We claim that different investors have different REPs and that it is impossible to determine the REP for the market as a whole, because it does not exist.

Keywords: equity premium; equity premium puzzle; required market risk premium; historical market risk premium; expected market risk premium; risk premium; market risk premium; market premium

JEL-codes: G12; G31; M21

18 pages, October 24, 2006

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