Returns in Indian Stocks From a fall in the ERP(Equity Risk Premium), States RBI
The recently published paper by RBI officials from the Division of Financial Markets states that Returns in Indian stocks over the past few years have come from a fall in equity risk premium (ERP) rather than higher earnings. The paper also provides insights about the rising stock prices irrespective of the earnings growth.
ERP is basically an extra return that promotes an investor for holding a risky asset. A fall in ERP implies that investors are more confident about that asset/stock. It also highlighted the risks posed by the rally driven by lower risk perceptions among investors rather than fundamental changes in their earnings.
As per the data from the 2016 to 2020 interval, the rise in the value of the stock was due to a fall in ERP, rather than higher profits from that asset. The paper also provides an estimation that ERP from 2005-2020 is around 4.7%. As investors assign a higher Price to Earn ratio, the value of the stock goes up, rather than their actual earning.
Vikas Gupta, founder, Omniscience Capital, a SEBI Registered Investment Advisory firm added facts that the long-term return on Indian equities is 10.6%, which is based on an ERP of 4.7% and a risk-free rate of 5.9%, after long-term capital tax it's still 9.5%. Overall, the ERP is consistent below 4 percent levels since 2016, whereas real GDP growth has remained below the 2016 level which was 8.7 percent earlier.