Equity risk premium (ERP)
TheoryDefinition
The extra return investors demand for owning stocks instead of risk-free government bonds. It compensates investors for bearing the higher volatility and drawdown risk of equities.
The ERP is the foundation of almost every valuation model. In a DCF, the discount rate (WACC) uses the ERP in the cost of equity: cost of equity = risk-free rate + beta × ERP. Change the ERP assumption by 1 percentage point and fair values for the S&P 500 can move 15–20%.
Historical ERP: about 4–6% per year for US stocks since 1928. Damodaran’s implied ERP (derived from current prices and expected future cash flows) usually sits between 4% and 6% and is a better real-time estimate than the long-run historical average.
The ERP is the foundation of almost every valuation model. In a DCF, the discount rate (WACC) uses the ERP in the cost of equity: cost of equity = risk-free rate + beta × ERP. Change the ERP assumption by 1 percentage point and fair values for the S&P 500 can move 15–20%.
Historical ERP: about 4–6% per year for US stocks since 1928. Damodaran’s implied ERP (derived from current prices and expected future cash flows) usually sits between 4% and 6% and is a better real-time estimate than the long-run historical average.
Formula
Cost of equity = Risk-free rate + Beta × Equity risk premium
Example
10-year Treasury yields 4%. If the ERP is 5%, the required return on the S&P 500 is 9%. A stock with beta 1.2 would require 4% + 1.2 × 5% = 10% as its cost of equity in a DCF.