Can anyone offer some insights on this?
Why does the Ibbotson Chen risk premium have the expected income component added seprately from the other components?
The other components - expected inflation, gdp real growth and P/E growth are all multiplied geometrically, but expected income is not and instead is added. Why is that so?
I think…
Because you are trying to to calculate equity risk premium, which is essentially just (return in equity market - RF rate)
(1xinflation)(1xreal growth rate in EPS) = nominal growth rate in EPS (or real GDP growth whichever you use)
(1xPEg) = nominal change in P/E ratio
nominal growth rate of EPS x nominal change in P/E ratio pretty much gives you what you expect to return in the market. But your return in the market is not complete without accounting for the dividends you will receive + any reinvestment gain you get from those dividends. That is why you add it.
It is like HPR: (P1 - P0)/ P0 = gain you get from capital appreciation + (CF1/P0) = gain you get from cash flow
You can kinda think of it like… HPR = (1xinflation)(1xreal growth rate in EPS) + dividend = return in equity market
Don’t mind me i’m just making stuff up as i go along. This is just how I visualize it though
Great explanation!! I always forget this formula but i guess not now.
Nice.