Equity Risk Premium

Intermediate

The equity risk premium is the extra return investors expect to earn from investing in shares rather than in risk-free assets, such as government bonds, over the long term.

Shares are riskier than government bonds: their prices are more volatile, dividends are not guaranteed and shareholders are paid last if a company fails. The equity risk premium is the reward investors expect for accepting these risks.

For example, if investors expect the stock market to return 8% a year over the long term and government bonds yield 4%, the expected equity risk premium is about 4 percentage points.

The equity risk premium is a key input in finance. It is used in the Capital Asset Pricing Model to estimate the cost of equity, which in turn affects how companies are valued and how they evaluate investments.

It cannot be observed directly. Analysts estimate it using historical returns, which have shown shares outperforming government bonds by several percentage points a year in many countries over long periods, or using forward-looking methods based on current dividend yields, earnings and expected growth. Different methods and periods produce different estimates.

The premium is not guaranteed in any given period. Shares can underperform bonds for many years, especially after periods of high valuations.

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