The equity premium and the required stock returns in a Tobin's q model with a stochastic discount factor

Based on the production-based Capital Asset Pricing Model (CAPM) principle, this article shows that earnings per unit of capital and the output capital ratio are excellent measures of expected stock returns because they are only temporarily affected by earnings shocks but affected permanently by changes in required share returns. Evidence for the US suggests that the risk premium is currently about 2% and that the covariance between consumption growth and expected returns is substantially lower than previously thought of; thus, reducing the equity puzzle substantially.