Equity Risk Premium
In short
Extra return investors demand for owning stocks instead of bonds
If government bonds pay 4% and investors demand 10% from stocks to compensate for the extra risk, the difference — 6 percentage points — is the equity risk premium. It's the extra return investors require, on average, for accepting stock market risk instead of a safer bond.
ERP is estimated two main ways: historically, as the average excess return stocks have realized over government bonds across some past period (commonly cited around 4–6% for US equities over long horizons, though sensitive to the start and end dates chosen), or implied, back-solved from current market prices and expected growth. It's a required input to CAPM, where cost of equity = risk-free rate + beta × ERP, and it feeds directly into WACC and DCF valuations. ERP isn't static — it tends to widen when investors are more risk-averse and demand more compensation to hold stocks, and compress during calmer markets. Because there's no single agreed method to estimate it, analysts using different ERP assumptions on the same company can reach meaningfully different valuations.
Formula
ERP = Expected Market Return - Risk-Free RateRelated concepts
- WACC — WACC is the average rate a company pays for all its funding — both equity (shareholders expect returns) and debt (banks charge interest). It's the minimum return a company must earn to create value.
- Risk-Free Rate — The rate you earn on the safest available investment, typically short- to medium-term government debt. Everything else gets compared against it — if a 10-year government bond pays 4%, why accept only 3% from a riskier stock or corporate bond with no extra compensation?
- Beta — Beta of 1.0 means the stock moves in line with the market. Beta of 1.5 means if the market rises 10%, this stock typically rises 15% — more volatile. Beta of 0.5 means less volatile than the market.