Equity Risk Premium What it is The equity risk premium (ERP) is the extra return investors expect to earn from holding stocks instead of a risk-free asset (typically government bonds). It compensates for the higher volatility, business risk, and potential for loss associated with equities. Key points:
ERP = expected return on equities − risk-free rate.
It is an estimate, not a guaranteed outcome; values vary with market conditions and methodology.
* ERP is forward-looking but often inferred from historical data, models, or surveys. Explore More Resources
Why it matters ERP is used to:
Price assets and estimate cost of equity.
Evaluate portfolio returns relative to safer alternatives.
* Inform long-term allocation and valuation models. Common methods to estimate ERP 1. Capital Asset Pricing Model (CAPM) CAPM links an asset’s expected return to market risk:
Ra = Rf + βa (Rm − Rf) Explore More Resources
Where:
Ra = expected return on the asset
Rf = risk-free rate
Rm = expected market return
βa = asset beta ERP for the market = Rm − Rf.
For a stock, the equity premium contribution = βa (Rm − Rf).
Example: if β = 1 and Rm − Rf = 5%, the stock’s market-related premium = 5%. Explore More Resources
2. Dividend-growth (Gordon Growth) approach Estimate expected equity return k from dividends and growth:
k = D / P + g Where:
D = expected dividends per share
P = current price
* g = expected dividend growth rate Explore More Resources
ERP ≈ k − Rf. 3. Earnings-yield approach Use earnings yield as a proxy for expected return:
k ≈ E / P Explore More Resources
Where E is trailing earnings per share. ERP ≈ (E/P) − Rf. 4. Survey method Collect forecasts of future equity returns from analysts, portfolio managers, and academics. ERP = average survey expected equity return − current risk-free rate. Explore More Resources
Pros: forward-looking and captures sentiment.
Cons: subject to sampling bias, behavioral biases, and short-term sentiment swings. 5. Building-block approach Sum premiums for specific risks:
Expected equity return = Rf + premium for business risk + financial risk + liquidity risk + other premiums. Explore More Resources
This makes risk sources explicit but requires subjective judgments about each component. 6. Multi-factor models (Fama–French) Extend CAPM by adding factors such as size (SMB) and value (HML):
Expected return = Rf + βm (Rm − Rf) + βSMB × SMB + βHML × HML Explore More Resources
This approach explains additional cross-sectional variation in returns beyond market risk. Factors that affect ERP estimates
* Choice of risk-free rate (short-term T-bills, long-term Treasuries, or TIPS for inflation-adjusted rates).
* Time horizon and historical period used.
* Valuation levels (booms and busts influence implied future returns).
* Survivorship bias—using long-lived markets can overstate typical premiums.
* Taxes, inflation expectations, and changes in market structure.
* Estimation error and model assumptions (steady growth, constant betas, priced factors).
Practical notes and implications
* ERP can be negative if expected stock returns fall below the risk-free rate—this implies investors prefer safe assets to equities given current expectations.
* Reported ERP estimates vary by method and period; many U.S.-market estimates in recent years have clustered in the mid-single-digit percentage range, but values move with market conditions.
* Use multiple methods (historical, implied, survey) to build a range rather than relying on a single number.
Takeaways The equity risk premium quantifies the additional return investors demand to hold equities over risk-free assets. It is essential for valuation and asset-pricing, but inherently uncertain. Combining methods and being explicit about assumptions (risk-free choice, horizon, growth expectations) produces more robust and defensible ERP estimates. Explore More Resources