Equity Risk PremiumERP
The equity risk premium is the extra return investors expect from stocks above the risk-free rate, as compensation for taking stock market risk. If stocks are expected to return 9% and Treasuries pay 4%, the premium is 5 points.
Why own stocks when government bonds pay a near-certain return? Because stocks are expected to earn more over time. That extra expected return is the equity risk premium, a cornerstone of valuation and asset allocation. This entry explains how it is measured, how it feeds into CAPM and why it changes over time.
- Category
- Fundamentals and Macroeconomics
- Reading time
- 3 min
- Also called
- Market risk premium, Stock risk premium, Equity premium
- Updated
The equity risk premium in plain words
The equity risk premium is the difference between returns on equity and the risk-free rate.1
It compensates investors for choosing riskier stocks over risk-free securities; the higher the risk, the higher the premium.1
In CAPM, the market risk premium is scaled by beta and added to the risk-free rate to give an expected return.2
How to estimate the ERP, step by step
Choose a risk-free rate
Usually a long government bond yield. See Risk-Free Rate.
Estimate expected stock returns
Historical averages or forward-looking models.
Subtract
Expected return − risk-free rate.
Cross-check
Compare with earnings yield methods. See Earnings Yield.
Use it in CAPM
Multiply by beta. See Capital Asset Pricing Model.
Update regularly
It changes with markets and rates.
Worked examples
Example 1 — Simple premium
5%Expected market return 9%, 10-year Treasury 4%.
| ERP | 9% − 4% = 5 points |
The premium is the excess return over the risk-free rate.1
Example 2 — In CAPM
10.5%ERP 5%, risk-free 4%, stock beta 1.3.
| Required return | 4% + 1.3 × 5% = 10.5% |
CAPM adds the beta-weighted risk premium to the risk-free rate.2
Example 3 — Implied premium from earnings yield
≈ 3.5%The market's earnings yield is 5.5%, real bond yields are 2%.
| Rough implied ERP | 5.5% − 2% = 3.5 points |
A lower implied premium suggests stocks are relatively expensive. See Earnings Yield.
Ways to estimate the ERP
| Aspect | Method | Weakness |
|---|---|---|
| Historical | Past stock minus bond returns | Depends on the period |
| Implied | From current prices and earnings | Needs growth forecasts |
| Survey | Asking investors or CFOs | Subjective |
| Used in | CAPM, DCF | See Discounted Cash Flow |
How the ERP is used
Cost of equity
Discount rates for valuation. See Discounted Cash Flow.
Asset allocation
Stocks vs bonds decisions. See Diversification.
Market valuation
Low premiums can signal expensive stocks.
Expected returns
Long-run planning.
Advantages and disadvantages
Advantages
- Core input for valuation.
- Links stock and bond markets.
- Simple concept.
Disadvantages
- Can't be observed directly.
- Estimates vary widely.
- Changes with conditions.
Going deeper
Read as far as you need. Each level builds on the one before it.
Risk-free benchmark
Beginner
The risk-free rate is usually taken from longer-term government bonds, assumed to have no default risk.1
Risk and premium
Intermediate
The premium and the level of risk move together: riskier equity demands a bigger premium.1
Time-varying
Advanced
Premiums tend to rise in crises when fear is high and fall in calm, expensive markets, which matters for timing valuations. See Market Sentiment.
Common mistakes
Treating it as guaranteed
It is expected, not promised.
Mixing short and long rates
Match the horizon.
Using one historical period
Results depend on dates.
Ignoring inflation
Use consistent nominal or real terms.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- The ERP is stocks' expected return above the risk-free rate.
- It compensates for equity risk.
- It is a key CAPM input.
- It can be estimated historically or implied.
- It changes over time.
Frequently asked questions
What is a typical equity risk premium?
Is ERP the same as market risk premium?
Can the ERP be negative?
Further learning
- Capital Asset Pricing Model
Where the ERP is used.
- Risk-Free Rate
The baseline.
- Earnings Yield
A way to imply the premium.
- Beta
Scales the premium per stock.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- Corporate Finance Institute. Equity Risk Premium (opens in a new tab) Checked .
- Corporate Finance Institute. Alpha (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.