What Is the Equity Risk Premium?
The equity risk premium is the expected return of the overall stock market minus the risk-free rate. If the market is expected to return 9% while ten-year Treasuries yield 4%, the ERP is 5%. It exists because equity holders sit last in line on a company's cash flows and endure far more volatility than bondholders, and rational investors require compensation for bearing that risk.
For US valuations, practitioners typically use an ERP in the range of roughly 4% to 6%. The premium is not directly observable, which is why estimates vary by source and methodology, and why the choice of ERP is one of the judgment calls that separates one bank's DCF from another's.
How It Is Estimated and Used
There are two dominant estimation approaches. The historical method averages realized stock returns over government bonds across long periods, often a century or more of US data. The implied (forward-looking) method, popularized by NYU professor Aswath Damodaran, backs out the premium from current market prices: given today's index level and consensus cash flow forecasts, it solves for the expected return that makes the math balance, then subtracts the risk-free rate.
The ERP plugs directly into CAPM: Cost of Equity = Risk-Free Rate + Beta x ERP. With a 4% risk-free rate, a beta of 1.2, and a 5% ERP, the cost of equity is 4% + 1.2 x 5% = 10%. That figure becomes the equity component of WACC, the discount rate applied to unlevered free cash flows in a DCF.
Why It Matters
Small changes in the ERP move valuations substantially. Raising the premium from 5% to 6% adds more than a full point to the cost of equity for a beta-1.2 company, which compounds across every forecast year and hits the terminal value hardest. Analysts defend their ERP choice by citing established sources such as Damodaran's monthly implied estimates or Kroll's recommended premium, and they sensitize valuations around it.
The concept also frames how professionals think about market conditions. A high implied ERP suggests investors are being paid generously to hold stocks, often after selloffs, while a compressed premium signals rich pricing. Interviewers ask candidates to define the ERP, place it within CAPM, and explain how they would justify a specific number.
