Download or read book Revisiting the Supply-Side Equity Risk Premium written by Gaurav Jetley and published by . This book was released on 2014 with total page 24 pages. Available in PDF, EPUB and Kindle. Book excerpt: There is an ongoing debate regarding whether the observed historical equity risk premium is too high to serve as a benchmark for forward-looking equity risk premium. To obtain estimates of forward-looking equity risk premium, a number of models have been proposed that link equity returns to the production of the real economy - the supply-side equity risk premium models. The supply-side models do not take into account any expected growth in the price-to-earnings (“P/E”) ratio because the models assume that the growth in the multiple is not related to actual economic activity. We show that the measures of supply-side equity risk premium that ignore growth in the P/E ratio are likely to be biased downward. This is because a part of the evolution in the P/E multiple can be associated with changes in technological innovation in the economy. Using patent grants as a proxy for technological innovation, we find that a non-trivial fraction of P/E ratio growth can be attributed to the growth of technology innovation, which we posit contributes towards the generation of returns. We also investigate the extent to which the P/E ratio is mean reverting and find that the actual process is consistent with our finding of a relationship between changes in P/E and technological evolution. Our findings suggest that the supply-side equity risk premium should be used with caution as it eliminates a non-trivial portion of returns that seem related to the “supply-side” of the economy.