Equity Risk Premium
Difference between the expected return on the equity market and the risk-free rate. The compensation investors demand for bearing equity (rather than risk-free) risk — the building block of CAPM.
When to use: Use to derive the ERP input to CAPM, or as a standalone read on equity-market risk pricing. Implied ERP (from current valuations and growth assumptions) often differs from historical ERP (typically 4-6% in US data) — the gap can signal market risk-on or risk-off regimes.
Formula
Variables
| Symbol | Name | Description | Unit |
|---|---|---|---|
| ERP | Equity Risk Premium | Market return minus risk-free rate, as a decimal | % |
| Rm | Market Return | Expected market return as a decimal | % |
| Rf | Risk-Free Rate | Risk-free rate as a decimal | % |
Real-Life Examples
Example 1: Implied ERP at 9% Market Return
Expected market return 9%, 10-year Treasury 4%.
Given
Step-by-Step
5% ERP — squarely in the historical 4-6% range. ERPs below 4% typically signal late-cycle compression (markets are paying full price for risk); above 6% signal stress and elevated risk premia.
Frequently Asked Questions
Historical ERP measures realized excess return over the past several decades — a backward look. Implied ERP backs out expected return from current valuations and forecasted cash flows — a forward look. Damodaran updates implied ERP monthly; that figure is the most cited "current" ERP.
Because it sets the discount rate. A 1% rise in ERP raises required returns and lowers fair-value estimates across the market. Tracking ERP regime helps explain why valuation multiples expand and compress over time.
No — emerging markets demand higher ERPs to compensate for political, currency, and liquidity risk. Country-specific ERP adjustments are routine in international DCF analysis (Damodaran publishes country premia).