Equity

CFA Level II Equities
#1

HI,

anybody can help me to understand how the formula for the GGM equity risk premium is derived?

GGM equity risk premium = Dividend yield year ahead + LT earnings growth rate - LT govt bond yield

Thanks

#2

Ups, sorry, it`s so easy…

#3

Yes its very easy… This is just DDM, re-arranged.

#4

Conceptually though, as an investor I really think we invest in equities for Dividends first (I gained this thesis via Robert Shiller years ago). Following that, we take on various forms of risk for capital appreciation, ie growth in earnings (not saying they are always correlated). Then of course, riskless return given by the bond yield is subtracted to represent what over and above we as investors are willing to bear for holding equities.

#5

GGM Model:

P0 = D1 / (r - g)

solve for r to get: r = D1/P0 + g

D1/P0 = div yield

r = required return on equity, which includes risk free rate (rf), so we subtract out the rf from both sides of the equation to get the equity risk premium:

r - rf = D1/P0 + g - rf