Measuring the Equity Risk Premium with Dividend Discount Models

This paper assesses the estimation of the so-called equity risk premium, i.e. the expected return on equities in excess of the risk-free rate, using the dividend discount model as the organizing framework. I compare the equity risk premium estimates from different dividend discount models in terms of the in-sample and out-of-sample forecasting ability across different time horizons. Using data from the Eurostoxx 50 from 2001-2021, I find that equity risk premium estimates exhibit similar dynamics, and are elevated during periods of high uncertainty, such as the onset of the COVID-19 pandemic. Moreover, I find that the three-stage dividend discount model, which divides earnings growth into an extraordinary, transitional and steady-state phase, performs the best in terms of forecasting ability