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Estimating the Equity Risk Premium with Time-Series Forecasts of Earnings

The size of the equity risk premium remains an unanswered question in the accounting and finance literature. This study proposes a new approach to reverse-engineer the equity risk premium, distinct from prior research, in that it does not rely on analysts’ forecasts to proxy for the market’s earnings expectations. That I instead use time-series earnings forecasts allows an investigation of the equity risk premium across a broader cross-section of firms, including smaller firms that are not covered by analysts. This study finds that risk premia are significantly higher for firms not followed by analysts. This suggests that studies requiring analysts’ earnings forecasts to estimate the equity risk premium have likely underestimated its overall level. Additional validity tests on my firm- and year-specific risk premium estimates reveal that these estimates consistently and predictably relate to multiple measures of risk, particularly for firms not followed by analysts.