How does the supply-side model estimate the equity risk premium and why is it preferred by some practitioners?

Question

AcadiFi · Accepted Answer

The supply-side model (Ibbotson-Chen) builds the expected equity return from the fundamental sources of equity returns rather than extrapolating past realized returns. This decomposition avoids the upward bias in historical returns caused by rising valuations (P/E expansion) that may not repeat.

**Supply-Side ERP Components:**

Expected Equity Return = Expected Inflation + Expected Real EPS Growth + Expected Income Return (D/P) + Expected Repricing (ΔP/E)

**ERP = Expected Equity Return - Risk-Free Rate**

**Worked Example (fictional forward-looking estimates, 2026):**

| Component | Estimate | Source |
|---|---|---|
| Expected inflation (CPI) | 2.5% | Central bank targets + breakevens |
| Real EPS growth | 2.0% | Long-run real GDP per capita growth |
| Dividend yield (D/P) | 1.5% | Current market yield |
| P/E repricing | 0.0% | Assume stable (no further expansion) |
| **Expected equity return** | **6.0%** | Sum of above |
| Risk-free rate (10Y govt) | 3.8% | Current yield |
| **Supply-side ERP** | **2.2%** | Equity return minus risk-free |

Compare this to the historical geometric ERP of ~5.5%. The gap arises because historical returns included ~1.5-2.0% from P/E expansion (valuations rose from single-digit P/E in the 1940s to 20+ by 2025) that is unlikely to repeat at current elevated levels.

\`\`\`mermaid
flowchart TD
    A[Supply-Side ERP Model] --> B[Expected Inflation]
    A --> C[Real Earnings Growth]
    A --> D[Dividend Yield]
    A --> E[P/E Repricing Assumption]
    B --> F[Sum = Expected Equity Return]
    C --> F
    D --> F
    E --> F
    F --> G[Subtract Risk-Free Rate]
    G --> H[Supply-Side ERP]
\`\`\`

**Advantages of Supply-Side:**
- Forward-looking rather than backward-looking
- Strips out non-repeatable P/E expansion
- Each component can be independently validated
- Less sensitive to sample period selection

**Criticism:** The model assumes the components are additive and independent, which may not hold during structural regime changes. It also requires judgment on the repricing component -- assuming zero repricing is itself a strong assumption.

How does the supply-side model estimate the equity risk premium and why is it preferred by some practitioners?

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