Equity Risk Premium
The excess return that investing in stocks is expected to provide over the risk-free rate, compensating investors for the higher risk of equities.
What is Equity Risk Premium?
The equity risk premium (ERP) is the additional return — above the risk-free rate — that investors demand for holding equities rather than risk-free assets such as U.S. Treasury bills. It reflects the compensation investors require for accepting the greater volatility, uncertainty, and loss potential of stocks. The ERP is a central input in the Capital Asset Pricing Model (CAPM): Expected Return = Risk-Free Rate + Beta × ERP. Historically, U.S. equities have generated an ERP of approximately 4–6% per year over long-run Treasury yields, though estimates vary by method (historical vs. implied). A higher ERP signals investor risk aversion; a lower ERP (or negative ERP) signals complacency. Aswath Damodaran at NYU Stern publishes widely used monthly ERP estimates based on implied calculations from current S&P 500 prices.
Example
In January 2024, the 10-year U.S. Treasury yield was approximately 4.0% and Damodaran's implied ERP was estimated at roughly 4.6%. A CAPM-based cost of equity for a stock with Beta = 1.2 would be: 4.0% + 1.2 × 4.6% = 9.52%. This rate is used as the discount rate in DCF valuation models to calculate the present value of future cash flows.