What is Equity Risk Premium?

Equity risk premium (ERP) is the difference between the expected return on equity and the risk-free rate. The ERP is often used as a tool to measure the relative attractiveness of investing in stocks. The ERP is an essential concept for investors to understand because it can help them make decisions about where to allocate their investment capital. In general, the higher the ERP, the more attractive stocks become relative to other investment options.  

Keep reading to learn more about the equity risk premium and how it can be used to make investment decisions. 

Equity Risk Premium, and Risk-free Rate of Return

Equity Risk Premium, put simply, is the return provided by a specific stock or by the whole market over and above the risk-free rate of return. The equity risk premium is the difference between the returns on individual stocks or equities and the risk-free rate of return. Longer-term government bonds can be used as a benchmark for the risk-free rate of return as there is no possibility of the government failing. It is the additional return that a stock gives to the investor in exchange for the risk the investor is incurring, over and above the risk-free rate. It serves as the investor's reward for choosing equity investments over risk-free products and assuming a higher level of risk. 

A direct correlation exists between equity risk premium and risk magnitude. The difference between stock returns and the risk-free rate increases as risk does, leading to a bigger premium. Additionally, empirical data is in favour of the equity risk premium concept. It demonstrates that by taking on more risk, every investor will profit in the long run. For a logical investor, an increase in an investment's risk must be matched by an increase in its potential profit for the investment to remain feasible.  

Equity Risk Premium calculator 

The difference between the rate of return on riskier stock investments, such as the S&P 500, and the return on risk-free assets is known as the equity risk premium, sometimes known as the "market risk premium." 

The term "risk-free rate" refers to the implied yield on a risk-free investment, with the 10-year U.S. Treasury note serving as the go-to proxy. Since the government could generate money if considered necessary, the U.S. government's bond issuances bear "zero risk" and defaulting on its commitments is thus unlikely. 

No sensible investor would take increased risk in the form of possible capital loss without the chance of a higher rate of return - that is, there must be an economic incentive for investors. The risk of holding stocks rather than government bonds is not justified if the potential reward for investors is insufficient. 

Equities have a lot more uncertainty about the investment outcome than bonds do, since they depend on the underlying company's profitability and free cash flow production, which are set in a bond's interest payment schedule and repayment schedule. 

Equity Risk Premium formula 

Equity Risk Premium (ERP) = Expected Market Return – Risk-Free Rate 

The return on the applicable stock exchange's index, in this case, the Dow Jones Industrial Average in the United States, can be used to determine the market's rate of return. Frequently, the risk-free rate for long-term government securities can be used as the current rate. 

Equity Risk Premium calculation 

The average yearly return (historical) of the S&P 500 index is 15% and the rate of return of the TIPS (30 years) is 2.50%. Then, the equity risk premium of the market would be 12.50% (i.e., 15% - 2.50%) = 12.50%. Therefore, in this case, the investor will need a 12.50% rate of return to participate in the market as opposed to government risk-free bonds. 

The company’s management will also be interested, in addition to the investors, because the equity risk premium will provide them with the benchmark return that they need to reach to draw in new investors. For example, consider XYZ Company's equity risk premium, which has a beta coefficient of 1.25 and a market equity risk premium of 12.5%. The investor will thus use the information provided to determine the company's equity risk premium, which equals 15.63% (12.5% x 1.25). This demonstrates that XYZ Company should create a rate of return of at least 15.63% to draw investors away from risk-free bonds and toward the firm. 

Conclusion 

The equity risk premium is the difference between the expected return on a stock and the risk-free rate. It is a measure of how much extra return investors expect to receive for taking on the risk of investing in stocks. The equity risk premium varies over time and is affected by a variety of factors, including economic conditions, inflation, and interest rates. 

FAQs 

Q. Does the equity premium equate to the risk premium? 

The excess return anticipated on an index or investment portfolio over the specified risk-free rate is known as the market risk premium. The predicted return of a stock over the risk-free rate, on the other hand, is represented by an equity risk premium, which only applies to stocks. 

Q. What affects the premium for equity risk? 

With changes in the economy, inflation expectations, interest rates, and monetary policy, the equity risk premium varies. The probability of an increase in the equity risk premium occurs when economic development slows and the stock market's outlook is bleak. 

Q. What leads to a decline in equities risk premium? 

Lower inflation, lower interest rates, looser monetary policy, less volatility, and an improvement in a company's outlook typically signal a drop in the equity risk premium. 

Q. Does a low equity risk premium make sense? 

The equity risk premium shows how much more money investors may make if they choose to invest in the stock market as opposed to government bonds. People should allocate a larger portion of their portfolio to stocks if the equity premium is high, and a smaller portion to bonds if it is low.