Editing Tesla, Inc.

In the typical case in which the equity risk premium is based on a national equity market index and estimated beta is based on sensitivity to that index, the assumption is being made implicitly that equity prices are largely determined by local investors. When equities markets are segmented in that sense (i.e., local market prices are largely determined by local investors rather than by investors worldwide), two issues with the same risk characteristics can have different required returns if they trade in different markets.

The opposite assumption is that all investors worldwide participate equally in set- ting prices (perfectly integrated markets). That assumption results in the international CAPM (or world CAPM) in which the risk premium is relative to a world market portfolio. In practice, the international CAPM is not commonly relied on for required return on equity estimation.

For estimating the required return on the equity using the Capital Asset Pricing Model, in terms of time period, and frequency of observations, the most common choice is five years of monthly data, yielding 60 observations. One study of U.S. stocks found support for five years of monthly data over alternatives. An argument can be made that the 2 years, weekly data can be especially appropriate in fast growing markets.

The beta value in a future period has been found to be on average closer to the mean value of 1.0, the beta of an average-systematic-risk security, than to the value of the raw beta. Because valuation is forward looking, it is logical to adjust the raw beta so it more accurately predicts a future beta.

|The equity risk premium is the incremental return (premium) that investors require for holding equities rather than a risk-free asset (e.g., government bills or government bonds). Thus, it is the difference between the required return on equities and a specified expected risk-free rate of return. The equity risk premium, like the required return, depends strictly on expectations for the future because the investor’s returns depend only on the investment’s future cash flows.  

Note: the definition of risk-free asset used in estimating the equity risk premium should correspond to the one used in specifying the current expected risk-free return.

Typically, analysts estimate the equity risk premium for the national equity market of the issues being analyzed (but if a global CAPM is being used, a world equity premium is estimated that takes into account the totality of equity markets).

'''Historical estimates'''

A historical equity risk premium estimate is usually calculated as the mean value of the differences between broad-based equity-market-index returns and government debt returns over some selected sample period. When reliable long-term records of equity returns are available, historical estimates have been a familiar and popular choice of estimation. If investors do not make systematic errors in forming expectations, then, over the long term, average returns should be an unbiased estimate of what investors expected. The fact that historical estimates are based on data also gives them an objective quality.

In using a historical estimate to represent the equity risk premium going forward, the analyst is assuming that returns are stationary—that is, the parameters that describe the return-generating process are constant over the past and into the future.

'''Forward-looking estimates'''

Because the equity risk premium is based only on expectations for economic and financial variables from the present going forward, it is logical to estimate the premium directly based on current information and expectations concerning such variables. Such estimates are often called forward-looking or ex ante estimates. In principle, such estimates may agree with, be higher, or be lower than historical equity risk premium estimates. Ex ante estimates are likely to be less subject to an issue such as non-stationarity or data biases than historical estimates. However, such estimates are often subject to other potential errors related to financial and economic models and potential behavioural biases in forecasting.