Equity Risk Premium (ERP)
ERP is the 'extra return' investors demand for taking the risk of owning stocks instead of safe government bonds. It's typically 5–7% and is a key input in WACC.
Definition
The equity risk premium (ERP) is the incremental return investors expect from investing in the stock market over a risk-free asset (typically long-term government bonds). It is a critical input in the CAPM formula: Cost of Equity = Risk-Free Rate + Beta × ERP.
CAPM: Cost of Equity
Re = Rf + B x (Rm - Rf)
10-Year US Treasury Yield
The baseline return you can earn with zero risk — what the US government pays to borrow money.
Regression vs. S&P 500
How sensitive this stock is to overall market movements. 1.2x means 20% more volatile than the market.
Historical market return minus Rf
The extra return investors demand for holding stocks instead of risk-free treasuries. Typically 5-7%.
1.2 x 6% = 7.2%
The company-specific risk premium: how much extra return this particular stock must offer, given its beta.
Cost of Equity Build-Up
Stacking the components from base to total
How ERP Is Estimated
There are two main approaches. Historical: calculate the average excess return of stocks over bonds over a long period (50–100 years). The Ibbotson/Duff & Phelps historical ERP is ~5.5–6.5% for U.S. equities. Forward-looking (implied): derived from current market prices using a dividend discount model. Professor Aswath Damodaran publishes monthly implied ERP estimates. Most banks use 5–7%.
ERP in CAPM and WACC
In CAPM, ERP is multiplied by beta to determine the stock-specific risk premium: Ke = Rf + β × ERP. A higher ERP increases the cost of equity, which increases WACC and decreases DCF valuations. ERP is the same for all stocks in a given market — beta adjusts the premium for individual company risk. Some analysts add a size premium for small-cap companies on top of CAPM.
Why ERP Matters for Valuation
A 1% change in ERP can swing a DCF valuation by 10–15% because it directly affects the discount rate applied to all future cash flows. During market crises, implied ERP spikes (investors demand more return for risk), which depresses valuations. In calm markets, ERP compresses. This is why the choice of ERP must be thoughtful and well-supported in any valuation analysis.
Worked Example — With Real Numbers
Using CAPM with a risk-free rate of 4.0%, ERP of 6.0%, and beta of 1.2: Cost of Equity = 4.0% + 1.2 × 6.0% = 11.2%. If you used an ERP of 5.0% instead, Cost of Equity = 4.0% + 1.2 × 5.0% = 10.0% — a 120bps difference that significantly impacts DCF value.
Key Takeaways
ERP represents the excess return investors demand for stock market risk over risk-free assets
Most banks use an ERP of 5–7% for U.S. equities
Small changes in ERP materially impact WACC and DCF valuations
ERP increases during market stress and compresses in calm markets
Common Mistakes in Interviews
Using a very short historical period to estimate ERP — use long-term averages (50+ years)
Confusing ERP with the total expected market return — ERP is the excess over the risk-free rate
Not adjusting ERP for country risk when valuing companies in emerging markets
How Interviewers Test This
If asked 'what ERP do you use?', a safe answer is 5.5–6.5% based on long-term historical U.S. equity returns (Duff & Phelps or Damodaran). Mention that you'd check current implied ERP estimates for reasonableness.
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