As central as it is to every decision at the heart of corporate finance, there has never been a consensus on how to estimate the cost of equity and the equity risk premium. Conflicting approaches to calculating risk have led to varying estimates of the equity risk premium from 0 percent to 8 percent—although most practitioners use a narrower range of 3.5 percent to 6 percent. With expected returns from long-term government bonds currently about 5 percent in the US and UK capital markets, the narrower range implies a cost of equity for the typical company of between 8.5 and 11.0 percent. This can change the estimated value of a company by more than 40 percent and have profound implications for financial decision making.
Discussions about the cost of equity are often intertwined with debates about where the stock market is heading and whether it is over- or undervalued. For example, the run-up in stock prices in the late 1990s prompted two contradictory points of view. On the one hand, as prices soared ever higher, some investors expected a new era of higher equity returns driven by increased future productivity and economic growth. On the other hand, some analysts and academics suggested that the rising stock prices meant that the risk premium was declining. Pushed to the extreme, a few analysts even argued that the premium would fall to zero, that the Dow Jones industrial average would reach 36,000 and that stocks would earn the same returns as government bonds.