From the most elementary standpoint, an equity risk premium is the amount of extra expected return you receive for taking on risk in equities vs a risk-less bond.
As I have found EV / EBITDA to be more useful than the standard P / E Ratio, I have decided to include that into these calculations. When you invert the Enterprise Value / Earnings before Interest, Taxes, Depreciation, and Amortization Ratio you get a sort of earnings yield, albeit from a private buyer’s perspective. To arrive at an ERP, the yield of a domestic risk-free government bond yield is subtracted.
This leaves us an estimated amount of excess return we should expect for taking on the risk of owning a business vs. owning a government-issued promise.
Similar to a junk-bond spread, it can give an indication as to how investors feel in terms of risk. As is often the case, investors flock to outperforming assets and shy away from the laggards. For example, if the equity risk premium is substantial, it may be the case that equities are out of favor. Alternatively, when it is nearly non-existent, there is less, if any, margin of safety.
Looking below we see the top 10 economies in terms of nominal GDP:
Two equity markets certainly stand out. Germany, which is cheap from a valuation standpoint, has the European Central Bank to thank for it’s lifeless Bund yield. Even with a US-equivalent yield substituted in, it looks like an appetizing market. Another standout, for the wrong reason this time, is India. With a government bond yield slightly outstretching it’s EBITDA yield, it seems as though faltering future growth is all that is necessary to erode any equity cushion.
Falling fast with India are the emerging economies of China and Brazil. An important point to bring up is that these volatile up-and-comers bear a larger likelihood of unforeseen risks than, say, the United States or Germany. At any rate, along with the linked post above, this table points out the possible merits of moving cash across borders.