In a ritual that now stretches back almost thirty years, I have updated equity risk premiums, by country, as of July 1, 2024. Comparing the numbers to the start of the year values, equity risk premiums have been trending down in 2024, with the US leading the way and country default spreads following. While I will be posting a much longer paper on the topic, a quick summary of the estimation process is below:
1. I use my implied ERP for the S&P 500 as of July 1, 2024, of 4.11% as my base premium for mature markets (all Aaa rated countries). https://lnkd.in/g33TEHzn
2. For non-Aaa rated countries, I use the sovereign rating to get a default spread, which I then scale up for the additional risk of equities (the scaling factor in July 2024 was 1.30).
3. For frontier markets, with no sovereign ratings, I use PRS country risk scores to estimate equity risk premiums.
You will notice that the UAE's constituents have different ratings, and equity risk premiums, and you will undoubtedly take issue with the equity risk premium for your country. These equity risk premiums, for better or worse, are driven by sovereign ratings, which can be wrong. If you download the full spreadsheet, you can see alternate estimates using sovereign CDS spreads. ( https://lnkd.in/g-eCKEzu )
In response to inflation and how it plays out in these numbers, here are the key things to remember:
1. Inflation is the central driver of your riskfree rates, not your equity risk premium. Thus, the choice of currency in which you compute expected returns matters, since the riskfree rate in Turkish lira will be much, much higher than the riskfree rate in US dollars. Once you make a currency choice for your expected return, you are then required to use the inflation rate in that currency in estimating your cash flows. If you do it right, your currency choice should not affect your valuation.
2. Since equity risk premiums are what you demand on an investment over and above the riskfree rate, in most cases, they will remain what they are, even when you switch currencies. The caveat is that in very high inflation currencies, with high riskfree rates, there may be a scaling effect on the equity risk premium. If that is your concern, you should estimate your expected returns in US dollars (since the ERP are in US dollars), and then do the following:
Cost of capital in local currency
= (1 + Cost of capital in US dollars) * (1+ inflation rate in local currency)/ (1+ inflation rate in US dollars) -1
Thus, if your cost of capital in US dollars is 9%, and the inflation rate is 70% in Turkish lira and 3% in US dollars:
Cost of capital in lira = (1.09) *(1.70/1.03) -1 = 79.90%
