Equity Risk Premium

The equity risk premium is the extra annual return investors demand for holding stocks instead of risk-free government bonds. It is the most important—and most debated—assumption in valuation. A 1% difference in the equity risk premium swings cost of equity by 1% and valuation by 15–25%.

What the equity risk premium is

Stocks are riskier than bonds. Bonds have priority in bankruptcy and a known maturity and coupon. Stocks are residual claims with uncertain cash flows. To compensate for this extra risk, investors demand an extra return.

If a 10-year Treasury yields 4% and the overall stock market is expected to return 9%, the equity risk premium is 5%. This premium has two interpretations: (1) the market expects stock returns to be 5 percentage points higher than bonds, or (2) the market requires 5% extra return to accept stock risk.

Historical estimates

From 1926 to 2024, US equities returned roughly 10% annually on average, and long-term bonds returned about 5–6%. This implies a historical equity risk premium of 4–5%.

But which average? Arithmetic mean (sum the annual returns, divide by count of years) gives roughly 5–7%. Geometric mean (compound growth rate) gives 4–5%. The choice matters: arithmetic mean is more relevant for forward-looking discount rates; geometric mean shows actual wealth accumulation.

A recurring surprise: Historical equity premiums (5–7%) are much higher than what economic theory would suggest based on investor risk aversion and dividend growth expectations. This is the equity premium puzzle. One explanation: stocks are genuinely very risky, and we underestimate that risk. Another: markets are irrational and overprice equity risk.

Current market estimates

Rather than relying solely on history, some estimate the equity risk premium from current market prices:

If the S&P 500 trades at a forward earnings yield of 5% (inverse of 20x forward PE), and long-term GDP growth is 2%, the implied equity risk premium is roughly 3%. (Earnings yield minus bond yield equals implied premium.)

This forward-looking estimate is often lower than historical, especially in periods of elevated valuations. In 2021, with forward PE ratios above 20x, implied equity premiums fell to 2–3%. In early 2024, with PE ratios lower, premiums rose to 4–5%.

The premium in CAPM

In the capital asset pricing model, the equity risk premium is the extra return demanded for the overall market. Cost of equity = Risk-free rate + Beta × Equity Risk Premium.

If the equity risk premium is 5% and a company has beta of 1.2, it demands an extra 6% return (1.2×5%) above the risk-free rate.

This is also called the market risk premium. It is the same thing: the premium for holding the market portfolio (all stocks) versus a risk-free asset.

Disagreement among practitioners

Surveys of CFOs, academics, and investors show equity risk premiums ranging from 4% to 7%. This wide range reflects genuine uncertainty, not just laziness.

Academics lean historical. Using 5–7% based on 1926–present data is academically defensible.

Practitioners are more cautious. Many use 5–6%, especially when valuations are elevated.

Emerging markets demand higher premiums. 6–10% is common for emerging-market equities, reflecting political risk, currency volatility, and lower liquidity.

Why the premium varies over time

In good economic times with low interest rates and high confidence, the equity risk premium compresses (investors become less risk-averse). In bad times with high rates and high uncertainty, the premium widens.

During the 2008 financial crisis, the equity risk premium briefly spiked to 8%+ as investors demanded enormous extra return to hold stocks. By 2016, with low rates and recovery underway, it had fallen to 3–4%. By 2024, it was back to 4–5%.

This time-varying premium is a problem for anyone trying to estimate a stable cost of equity. Should your DCF valuation assume today’s risk premium or a long-term average?

The size and value premiums

Beyond the market-wide equity risk premium, there are additional premiums for holding small stocks (size premium) or cheap stocks (value premium). These are often 2–5% annually. This is why the Fama-French three-factor model is popular: it captures these additional premiums.

Practical implications for valuation

Using a fixed equity risk premium. Assume 5% or 6% based on historical data or consensus, and apply it consistently. This is the most common approach. It is simple and defensible.

Using a forward-looking premium. Estimate what the market is currently pricing in based on valuation levels. This varies over time and reflects current sentiment. It is more realistic but harder to justify.

Running scenarios. Build DCF models at 4%, 5%, 6%, and 7% equity risk premiums. If the valuation range is narrow, you have confidence. If it is wide, you are betting heavily on a precise premium estimate.

Accounting for company-specific risk. The equity risk premium is the market-wide premium. An individual stock might have additional risk (concentration, cyclicality, execution risk), which shows up in its beta but is worth making explicit.

See also