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The last bit of information required to calculate the expected return of a stock is the market risk
premium, which is the difference between the expected return of the overall stock market and the riskfree
rate of return. Unfortunately, the expected return of the overall market of risky stocks is not
observable, so we cannot directly calculate the market risk premium. We instead use a proxy for this
market risk premium based on available historical information about the returns earned by the market
of risky stocks and risk-free U.S. Treasury bonds. This information was presented for large company
stocks and U.S. Treasury bonds in Exhibit 5.2 earlier in the chapter, and these historic average annual
returns for large company stocks and U.S. Treasury bonds for the 80-year period from 1926 to 2005
are presented in Exhibit 5.7.
From this information, we see, on average, over 80 years, an investment in the common stock of
large companies returned 6.5% (12.3% - 5.8%) more than an investment in U.S. Treasury bonds.
Stated in CAPM terms, the premium earned by investing in the market of risky stocks versus investing
in risk-free securities was 6.5%. This is what we will use as the market risk premium in the CAPM
equation, the difference between average annual returns earned by large company stocks and the
average annual returns earned by U.S. Treasury bonds. We have a long time series of average annual
returns earned by large company stocks and U.S. Treasury bonds, and we will use the difference
between these two average returns as a proxy for the market risk premium.
Exhibit 5.7 Average annual returns, 1926-2005.
Source: Modified from Stocks, Bonds, Bills, and Inflation: 2006 Yearbook, Ibbotson Associates, Inc.
With the risk-free rate of return, the beta coefficient for a stock, and the proxy for the market risk
premium, the expected return of any stock can be calculated. For the Walt Disney Company the
calculation is:
This is the CAPM expected return for Disney stock. For the other firms listed in Exhibit 5.5, their
lower or higher beta coefficients result in lower or higher rates of expected return. For PepsiCo, this
expected return is 8.10%; for Boeing, this expected return is 10.70%, which is also the expected return