ValuationERP

What is the Equity Risk Premium (ERP)?

The Equity Risk Premium (ERP) is the excess return investors demand for holding equities over risk-free assets such as US Treasury bills. In the United States the ERP has historically ranged between 4% and 6%. It is a critical input in the Capital Asset Pricing Model (CAPM) and flows directly into the Weighted Average Cost of Capital (WACC) used to discount future cash flows.

Formula

ERP = Expected Market Return - Risk-Free Rate

Why the ERP Matters to Value Investors

The ERP is not just an academic number -- it is the dial that sets the entire level of equity valuations relative to bonds. When the ERP is low, stocks are priced as if the future is certain. When it is high, stocks are priced for meaningful uncertainty. Value investors like Howard Marks and Seth Klarman view a compressed ERP as a warning sign that markets are complacent and that the margin of safety is thin.

In a DCF model, even a 0.5 percentage point increase in the ERP raises WACC meaningfully, especially for long-duration growth stocks whose cash flows are weighted far into the future. This is why rising interest rates and risk-off sentiment simultaneously compress multiples: both forces push the ERP up and therefore push intrinsic value estimates down.

Calculate WACC

The ERP flows directly into WACC through the CAPM cost-of-equity formula. Use our free WACC Calculator to see how changing the ERP shifts your discount rate.

Open WACC Calculator →

Frequently Asked Questions

What is the equity risk premium?+

The equity risk premium is the additional return an investor expects from holding stocks compared to a risk-free investment such as a 10-year US Treasury bond. It compensates investors for the higher uncertainty and volatility inherent in equities. A higher ERP means investors require more compensation for equity risk, which raises discount rates and lowers valuations.

What is the current equity risk premium?+

The implied ERP fluctuates with market prices and interest rates. As of recent estimates by Aswath Damodaran, the US implied ERP typically sits between 4% and 6%. During market stress periods it can spike above 7%, while in buoyant markets it can compress below 4%. Always use a freshly estimated forward-looking ERP rather than a long-run historical average when discounting near-term cash flows.

How is ERP used in WACC?+

In WACC, the cost of equity is calculated as: Cost of Equity = Risk-Free Rate + Beta x ERP. A higher ERP raises the cost of equity, which in turn raises WACC. A higher WACC compresses the present value of future free cash flows in a DCF model, reducing intrinsic value estimates. Even a 1 percentage point change in ERP can move a fair-value estimate by 15-25% for high-growth companies.

Who sets the equity risk premium?+

No single authority sets the ERP. It is an emergent market price implied by current stock prices relative to expected earnings and the prevailing risk-free rate. Practitioners commonly rely on estimates published by Aswath Damodaran (NYU), who updates country-level ERPs monthly, or survey-based estimates from sources such as the Duke CFO Survey.