Confirming the RBA’s 4% Equity Risk Premium remains relevant
Compensation for risk is a foundational pillar of finance. In both the bond and equity market we talk about spread, although in the equity market its name is equity risk premium.
In November I explained why 4.8% was a reasonable return for Australian equity investors (see here) based on RBA analysis.
Reasonable discount rates to account for risk is critically importance for a rational investor so its worth firming up that analysis the RBA completed over the 102 years to 2019 with some more current analysis.
Below you will see an analysis of the S&P/ASX 200 from 2000 to 2019 and also the 5 years to end 2019 which firms up the RBA’s analysis.
There is a great deal to unpack in this data.
Firstly the compound annual growth rate of the S&P/ASX 200 index (excluding dividends) has been around 4.2% over the 21st Century and 4.3% over the last 5 years. As at Friday 4th December 2020 the 2 year Australian Government Bond was yielding 0.09% and the 10 year 0.34% - lets call that roughly 0.2%.
Over these shorter and more recent periods the Australian equity market has largely vindicated the appropriateness of the far larger analysis undertaken by the RBA.
Three other points also need to be raised here with regards to the Australian market. Firstly the growth rate in earnings has slowed in recent years. Secondly the proportion of earnings paid out in dividends has increased. Finally the lower amount of profits being reinvested back into companies lowers the future growth of businesses confirming our market is more focused on dividend income than it is on future earnings growth.