Decreased Equity Risk Premium: Estimation Based on Dividend-Equivalent Earnings

Using US stock market data spanning from 1871 to 2024, this article examines whether the equity risk premium required by investors (ERP) has decreased. Economic models and institutional developments suggest that the ERP should be lower. Ascertaining changes in the ERP, however, is difficult because the realized equity risk premium (ERPLZ) can be a misleading measure of the ERP. The ERPLZ depends largely on capital gains which, in turn, depend on changes in the ERP during the investment period. To overcome this difficulty, this article estimates the ERP based on dividend-equivalent earnings, which combine hypothetical capital gains and dividends into a single stream of cash flows. The main finding is that the ERP significantly decreased during the sample period, especially in the 1980s. The estimated decrease is over 2.5 percentage points.