I am trying to make sense of how ERP adjustments as mentioned in text would affect valuations. As historical positive events are not expected to repeat in future a downward adjustment to ERP is suggested. This adjustment should provide a lower required rate of return (r) using CAPM. This lower value of r when used in discount models should provide higher valuations. How can we make sense of this conclusion putting all these together - as positive events of past are not expected to repeat in future, we lower the ERP which will provide higher valuations in absence of those positive events?
Level 2 Volume 2 Reading 21 ■ Return Concepts, page 295
“For example, a string of positive inflation and productivity surprises may result in a series of high returns that increase the historical mean estimate of the equity risk premium. In such cases, a forward-looking model estimate may suggest a much lower value of the equity risk premium. To mitigate that concern, the analyst may adjust the historical estimate downward based on an independent forward-looking estimate (or upward, in the case of a string of negative surprises). Many experts believe that
the historical record for various major world markets has benefited from a majority of favorable circumstances that cannot be expected to be duplicated in the future;”