What is the supply-side ERP methodology (Ibbotson-Chen)?

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AcadiFi · Accepted Answer

The supply-side (Ibbotson-Chen) ERP decomposes historical equity returns into fundamental economic components to estimate a sustainable forward ERP. Decomposition framework: Equity return = Inflation + Real EPS growth + P/E expansion + Dividend yield Then: ERP = Equity return − Risk-free real rate − Inflation = Real capital gains + Dividend yield − Real risk-free rate Ibbotson-Chen version (1926-current historical data): ERP = (1 + g_real_EPS) × (1 + inflation) × (1 + ΔP/E) × (1 + div_yield) − 1 − Rf But the supply-side adjustment strips out the historical P/E expansion because it's not sustainable: Supply-side ERP = Historical ERP − Historical P/E expansion Components (historical 1926-2025): - Inflation: ~2.9% - Real EPS growth: ~2.1% - P/E expansion: ~0.6% per year (unsustainable) - Dividend yield: ~3.9% - Nominal equity return: ~9.5-10.0% - Risk-free real rate: ~0.5% Historical ERP (geometric, over T-bills): ~6.5-7.0% Supply-side ERP (subtracting P/E expansion): ~6.0% Current forward supply-side estimate: - Expected inflation: 2.25% - Real EPS growth: 2.0% (long-run GDP-like) - Dividend + buyback yield: 3.0% - Expected nominal return: approximately 7.25-7.5% - Minus 10Y Treasury 4.25% = ERP of 3.0-3.25% Why does supply-side differ from historical? - Historical includes one-time valuation re-rating (P/E rose from ~10x in 1980 to ~22x today) - That multiple expansion adds ~0.6-1.0% to realized returns - Going forward, P/E expansion unlikely to repeat CFA curriculum framing: - Supply-side is considered more rigorous than pure historical - Usually yields 100-150 bps lower than historical - Preferred for DCF and CAPM applications ```mermaid flowchart LR A[Historical ERP
~6.5%] --> B[Subtract P/E
Expansion] B --> C[Supply-Side ERP
~6.0%] C --> D[Forward Adjustment
Current Yields] D --> E[Forward ERP
~3-4%] ``` Limitations: - Assumes long-run EPS growth equals GDP growth (empirically close) - Sensitive to whether buybacks are treated as dividends - Doesn't capture regime shifts (technology productivity, deglobalization)

What is the supply-side ERP methodology (Ibbotson-Chen)?

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