What it means
Shares can and do fall heavily, sometimes for several years in a row, and there is no promise of any payment along the way. A rational investor will therefore only choose shares over government bonds if the expected return is meaningfully higher.
The equity risk premium is exactly that gap, quoted as a percentage a year. It matters because it is the bridge between the safe rate anyone can earn and the return a specific business must deliver.
Slot it into the capital asset pricing model alongside a company's beta and you get that company's cost of equity, which in turn drives the discount rate used to value it. This makes the premium one of the most consequential numbers in corporate finance.
Analysts estimate it in three broad ways. The historical approach measures how much shares have beaten bonds by in the past, the implied approach reverse-engineers the premium from today's share prices and expected cash flows, and the survey approach simply asks professional investors what they are using.
In practice most large firms settle on a figure in the 4% to 6% range for developed markets. The premium is not fixed and moves with the mood of the market.
It widens during crises, when investors demand far more compensation to hold risky assets, and narrows in calm periods when confidence is high. This is one reason valuations fall sharply in a panic even when the underlying businesses have not changed much.
Emerging markets attract an additional country risk premium on top of the base figure, reflecting weaker legal protection, currency instability and political uncertainty. A valuation of a business operating in several countries may therefore blend different premiums weighted by where the profits actually arise.
Whatever approach is chosen, the assumption should be stated openly and tested, because a valuation that only works at one specific premium is a fragile valuation.
In practice
Real-world examples.
Example
A private equity firm valuing a chain of veterinary clinics uses a 5.5% equity risk premium. When market volatility spikes and the firm raises the assumption to 7%, the offer price for the target drops by roughly 14% and the deal is renegotiated.
Example
A telecoms group with operations in two emerging markets adds a 3% country risk premium to its base 5% figure for those units. The resulting 8% premium raises the hurdle rate on a proposed network build from 10% to 13%, and the project is deferred.
Example
A corporate treasurer preparing an annual impairment review documents the 5% premium used, the source of the estimate and a sensitivity table showing the result at 4% and 6%. The auditors accept the assumption because the reasoning is written down rather than asserted.
Think of it
“Equity risk premium is the extra return you expect for investing in stocks versus safe bonds.
Formula
Calculation
Equity risk premium = expected return on the market - risk-free rate
Suppose analysts expect a broad share index to return 9.0% a year over the long run, and ten-year government bonds currently yield 4.0%.
Equity risk premium = 9.0% - 4.0% = 5.0%
Now apply it to a specific company. A regulated water utility has a beta of 0.8, because its earnings are far steadier than the market as a whole.
Cost of equity = risk-free rate + (beta x equity risk premium) = 4.0% + (0.8 x 5.0%) = 4.0% + 4.0% = 8.0%
If instead the analyst used a 6.5% premium, the cost of equity would rise to 4.0% + (0.8 x 6.5%) = 9.2%. On a business generating $12,000,000 of steady annual cash flow valued as a perpetuity, that shift moves the valuation from $12,000,000 / 0.08 = $150,000,000 down to $12,000,000 / 0.092 = $130,400,000, a fall of nearly $20,000,000 from one assumption.Case study
Seen in the real world.
Calderwood Instruments is an invented company used here as a purely illustrative example. It was preparing to sell a division and hired two advisers, who came back with valuations of $210,000,000 and $168,000,000 for the same set of forecasts.
The gap turned out to have almost nothing to do with the trading projections. One adviser had used an equity risk premium of 4.5% inherited from a long historical average, while the other had derived an implied premium of 6.2% from current market prices during an unsettled quarter. Everything else in the two models was broadly aligned.
The board asked both advisers to rerun the numbers at a common 5.5% premium and to show the valuation at 4.5% and 6.5% as well. The resulting range of $175,000,000 to $200,000,000 gave the directors an honest negotiating band, and the division eventually sold at $186,000,000 without anyone pretending a single point estimate had been correct.
Watch out
Common mistakes.
- Treating the premium as a fixed constant rather than a market-driven figure that widens in downturns and narrows in calm periods.
- Pairing a premium measured against short-term bills with a long-term government bond yield, which overstates the total required return.
- Applying a single developed-market premium to operations in countries with far greater political and currency risk.
Questions
People also ask.
How is this different from the equity premium?
The terms overlap heavily, but the equity risk premium usually refers to the forward-looking compensation required today, while the equity premium is often used for the return actually realised in the past.
Does a higher premium make companies look more or less valuable?
Less valuable, because a higher premium raises the discount rate applied to future cash flows, which shrinks their present value.
Who decides what premium to use?
There is no official figure, so each firm chooses one from published research, implied market estimates or professional surveys, and should disclose its choice in the valuation.
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