Equity Risk Premium
The Equity Risk Premium (ERP) is the excess return that investing in the stock market provides over a risk-free rate, compensating investors for the higher volatility and uncertainty of equity ownership compared to holding default-free government securities.
The Equity Risk Premium is arguably the single most important number in equity valuation. It appears in the CAPM formula — Re = Rf + Beta x ERP — and therefore feeds directly into cost of equity, WACC, and every DCF model. A 1-percentage-point change in the ERP shifts discount rates across the entire equity market, moving valuations by trillions of dollars in aggregate.
Estimating the ERP is part science, part judgment. The historical approach takes the arithmetic or geometric average excess return of US equities over T-bills or T-bonds over long periods. Using Ibbotson/Morningstar data, US large-cap stocks have delivered roughly 5.5-7% above T-bills on an arithmetic basis since 1926, and about 4-5% on a geometric (compound) basis. The geometric figure better reflects investor wealth accumulation; the arithmetic figure is technically correct for forward-looking discount rates. Which number to use is a genuine and unresolved debate among practitioners.
Forward-looking (implied) ERP estimates are increasingly preferred by academics like NYU professor Aswath Damodaran, who publishes monthly updates. The implied ERP is derived by back-solving the dividend discount model for the S&P 500: given current index prices, consensus earnings forecasts, and an assumed long-run growth rate, what ERP makes the discounted cash flow equal the observed market price? This approach automatically incorporates current market sentiment and interest-rate levels. As of early 2026, with the 10-year Treasury near 4.5%, Damodaran's implied ERP for US equities hovered around 4.5-5%, yielding a total cost of equity for an average-risk (beta = 1.0) US company of roughly 9-9.5%.
The ERP is not static. During the 2008 financial crisis and again in March 2020, implied ERPs spiked as investors demanded higher compensation for equity risk even as Treasury yields fell — reflecting a flight to safety. Conversely, during the low-volatility, low-rate era of 2017-2019, compressed ERPs helped push equity multiples to historically high levels. Analysts building long-run valuation models should use a normalized ERP rather than the prevailing spot estimate, which can be distorted by short-term sentiment. A range of 4.5-5.5% is commonly used for US equities in long-horizon models.