Many investors estimate the market risk premium using historical averages. However, the Gordon growth model can be algebraically manipulated to create a forward-looking market risk premium based on the current market valuation. Such a model should help estimate the actual return investors should expect from investing in the stock market.
Estimating the risk premium in this way is simple. Start with the dividend yield on the market index, add the consensus long-term earnings growth rate and subtract the current long-term government bond yield.
At the time of writing, the dividend yield on the S&P 500 is 2%, the consensus earnings growth rate is about 8% and the yield on the 10-year treasury is about 5%. 2% + 8% – 5% = 5%, which is in line with the historical average market risk premium.For more information, see all articles on: Investing in Stocks, Investment Returns, Portfolio Management, Security Selection, Valuation See also: