Re-examination of the historical equity risk premium in Australia

In light of the ongoing debate over the value of the equity risk premium, its increasing use in the regulatory setting, and the impact of dividend imputation on the premium, this paper presents a timely new look at the historical equity risk premium in Australia, and provides an improved understanding of the historical record. We document concerns about data quality that become increasingly important the further back in time one looks. In particular, there are sufficient question marks over the quality of data prior to 1958 to warrant any estimates based thereon to be treated with caution. Accordingly, we present a new set of estimates of the historical equity risk premium corresponding to periods of increasing data quality but of decreasing sample size. Relative to bonds (bills), the equity premium has averaged 6.3 per cent (6.8 per cent) per annum over 1958-2005, which is a period of relatively good data quality. Together with other results in the paper, the findings reveal a historical estimate that is substantially less than widely cited historical studies would otherwise indicate. We reconcile prior evidence through documenting a dividend adjustment that has typically been overlooked. We also provide estimates that incorporate an adjustment for imputation credits.