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Equity Risk Premium

Equity Risk Premium

The KPMG Lower Gulf valuation team continually endeavors to carry out independent in-house research on valuation related matters. Below is a summary of our recent observations and possible inferences on one key valuation parameter, the Equity Risk Premium (ERP) in the United Arab Emirates (UAE), used in the derivation of cost of equity for regional businesses. Given the dynamic nature of this crucial metric, our aim is to derive the ERP on a quarterly basis and share the results with a larger audience. Our analysis and its outcome suggests an implied ERP of 6.6% on 31 March 2018.

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UAE economic outlook

It appears that the UAE’s GDP growth has comparatively slowed in recent years, driven by falling oil prices, the general slow down in the global economy, and a challenging geo-political situation in the Middle East. Despite these factors, the UAE’s GDP growth is expected to improve in the near future, driven primarily by continued economic diversification geared toward further reducing dependence on the petroleum sector.

General concept

The ERP is the excess return of the stock market over the risk-free rate. It represents the additional return investors require from an equity investment to reflect the additional risk in the asset compared to a ‘risk-free’ asset.

Despite the relatively straightforward nature of the ERP concept, its derivation is more complicated, as practitioners use various methods. Three key approaches to deriving ERP can be discerned:

  • Historical premiums: this methodology assumes that expected ERP can be derived by studying historical equity returns. Although well established and theoretically sound, potential for its application in the UAE is limited due to the lack of a sufficiently long and detailed history for regional indices. 
  • Implied premiums: ERP is derived by assessing current prices, growth, and return expectations. This methodology is also well established and theoretically sound, and furthermore allows for incorporation of the most recent market developments. It is, however, sensitive to the inputs used. 
  • Survey premiums: surveys provide study participants’ current views.
     

Historical ERP findings

Historically, for 2012 -2016, ERP appears to have ranged between ~4.5% - ~7.5% for developed markets. This is based on estimates and surveys of various practitioners and academics, including Damodaran, Fernandez, and global KPMG research. While data for the GCC region is more limited, the range over the last three years appears to have been ~5.5% - 8%, excluding outliers.

KPMG methodology

Our model is based on the implied premium methodology and calculates the potential returns of the market.

Key assumptions for the UAE

  • KPMG’s ‘market’ has been selected from the equity stocks listed on Dubai Financial Market, Abu Dhabi Securities Exchange, Nasdaq Dubai, and the MSCI UAE Index. The selected KPMG index consists of financial services (43%), telecommunication (27%), real estate (17%), and others (13%), weighted by market capitalization.
  • Consensus estimates have been considered for estimating returns in the explicit period; long-term growth estimates have considered expected long-term growth, as well as inflation expectations for the UAE economy.
  • The risk-free rate has been developed using 20-year US government bond yields, adjusted for inflation differential and country risk premium for the UAE.
     

Limitations of the methodology

The results of the exercise are dependent on the inputs used, including the selection of income or return proxies (e.g. dividends, buy-backs, cash flow) and the basis of expected growth rates (e.g. macroeconomic considerations, consensus forecast estimates). Further, as the UAE market deepens, it continues to face some limitations in terms of free float, traded volumes, and analyst coverage. We will continue to monitor these factors closely and refine our inputs.
 

Equity Risk Premium for the UAE

Our analysis points to an ERP of 6.6% as of 31 March 2018.

Our estimation is based on information available on 31 March 2018. Developments in the market after this date can have an impact on the perceived market risk, which is not reflected in the ERP estimate on 31 March 2018. As a general comment, we would point out that individual input parameters for a discount rate calculation should never be assessed in isolation.

Please note that this is a summary document only. Should you require more detailed information on the methodologies used to derive the ERP, please do not hesitate to contact us directly.
 

© 2018 KPMG Lower Gulf Limited, registered in the UAE and a member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. All rights reserved. Printed in the United Arab Emirates. The KPMG name, logo and “cutting through complexity” are registered trademarks or trademarks of KPMG International.

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