Equity Risk Premium (ERP)

Glossary Term • Intermediate • 3 min read

Audience: Model Developers • Equity Research • Auditors
Last Reviewed: July 2026
Updated: Version 1.0

Executive Summary

The equity risk premium (ERP) is the additional return equity investors require, above the risk-free rate, for bearing the risk of holding equities as an asset class rather than a risk-free instrument. ERP is not directly observable and must be estimated, typically from long-run historical average equity returns in excess of government bond yields, from implied ERP models that back the premium out of current market prices, or from surveys of practitioner expectations. ERP is a required input to the Capital Asset Pricing Model (CAPM), where it is multiplied by beta to determine the equity-risk component of cost of equity. Because reasonable ERP estimates can differ materially between sources, the ERP figure used in a valuation should always be disclosed alongside its source and date.

Key Takeaways

✓ The equity risk premium is the excess return equity investors require over the risk-free rate for bearing equity market risk.
✓ ERP is not directly observable and must be estimated using historical, implied, or survey-based methods.
✓ ERP is multiplied by beta in the CAPM formula to determine the equity-risk component of cost of equity.
✓ Different ERP sources can produce materially different estimates, so the source and date used should always be disclosed.
✓ ERP is distinct from country risk premium and size premium, which are separate additive adjustments for specific risk factors beyond general equity market risk.

Definition¶

The equity risk premium (ERP), also called the market risk premium, is the additional return equity investors require, above the risk-free rate, for bearing the risk of holding equities as an asset class. ERP is a required input to the Capital Asset Pricing Model (CAPM), used to build cost of equity in a DCF valuation.

Formula and Role in CAPM¶

ERP = Rm - Rf

Where:
Rm = Expected return on the broad equity market
Rf = Risk-free rate

Within CAPM, ERP is multiplied by beta to determine the equity-risk component of cost of equity:

Cost of Equity = Rf + β × ERP

Estimating ERP¶

Because ERP is forward-looking and not directly observable, three broad estimation approaches are used in practice:

Historical ERP. The average excess return of a broad equity index over government bonds, measured over a long historical period. Results are sensitive to the period chosen and to whether an arithmetic or geometric mean is used.
Implied ERP. Backed out of current market prices using a dividend discount or similar forward-looking model, under the assumption that the market as a whole is fairly priced. Implied ERP moves with market conditions and is generally considered more responsive than historical ERP.
Survey-based ERP. Aggregated estimates drawn from surveys of academics, practitioners, or chief financial officers.

These approaches can produce materially different results, which is why institutional practice requires the ERP figure, its source, and its as-of date to be explicitly disclosed alongside the valuation.

Relationship to Country and Size Premiums¶

ERP represents the general premium for bearing equity market risk in a mature, well-diversified market. It is distinct from, and additive to, other risk premia that may apply to a specific valuation: the country risk premium for cash flows exposed to a specific country's sovereign or political risk, and the size premium sometimes added for smaller companies. Each should be separately identified rather than blended into a single unexplained cost-of-equity adjustment.

Audit Considerations¶

Confirm the ERP source, methodology (historical, implied, or survey-based), and as-of date are disclosed
Confirm the ERP figure is applied consistently with the market on which the risk-free rate and beta are based
Check that country risk premium and size premium, where applied, are separately identified rather than embedded silently within the ERP figure
Assess whether the ERP used falls within the range generally considered defensible by institutional practice, and flag outlier figures for further inquiry

Common Errors¶

Error	Description	Risk
Undisclosed ERP source	ERP figure used without stating methodology or date	Cannot be independently assessed or replicated
Blended premium	Country or size premium folded into the ERP figure without separate disclosure	Obscures which risk factor is driving the discount rate, and complicates comparability
Mismatched market basis	ERP sourced from a different market than the risk-free rate or beta	Internal inconsistency in the cost of equity build

Continue Reading¶

Prerequisites¶

Discounted Cash Flow (DCF) Valuation — the parent pillar
CAPM (Capital Asset Pricing Model)

How to Build WACC

How OXXON tests thisRun a free structural check with FMAE

Frequently Asked Questions

What is the formula relationship between ERP and the risk-free rate?

ERP is conceptually defined as the expected market return minus the risk-free rate: ERP = Rm - Rf. In the CAPM formula, ERP is the term multiplied by beta: Cost of Equity = Rf + Beta x ERP.

How is ERP estimated in practice?

Three broad approaches are used, historical ERP (the average excess return of equities over government bonds over a long historical period), implied ERP (backed out of current market prices using a dividend discount or similar model, under the assumption that the market is fairly priced), and survey-based ERP (aggregated estimates of practitioner or academic expectations).

Why do ERP estimates vary between sources?

Because different methodologies, historical periods, geographic markets, and averaging conventions (arithmetic versus geometric mean) produce materially different results. There is no single universally accepted ERP figure, which is why the source and date of the ERP used in a valuation should always be disclosed.

Is ERP the same as country risk premium?

No. ERP represents the general premium for bearing equity market risk in a mature, diversified market. Country risk premium is a separate, additive adjustment applied specifically for cash flows exposed to a particular country's sovereign or political risk beyond that captured in the base ERP.

Does a higher ERP increase or decrease valuation?

A higher ERP increases cost of equity (holding beta and the risk-free rate constant), which increases the discount rate and therefore decreases the present value of future cash flows, all else equal.

CAPM (Capital Asset Pricing Model)

The Capital Asset Pricing Model (CAPM) is the standard methodology for estimating the cost of equity — the return equity investors require to hold a company's stock, given its systematic risk relative to the broader market. CAPM expresses cost of equity as the risk-free rate plus the company's beta multiplied by the equity risk premium (the excess return the market as a whole is expected to earn over the risk-free rate). CAPM is the most widely used cost-of-equity methodology in institutional valuation practice and is the standard input to the cost-of-equity component of WACC.

Risk-Free Rate

The risk-free rate is the theoretical rate of return on an investment carrying no default risk. In practice, no investment is entirely free of risk, so the risk-free rate is proxied by the yield on a highly creditworthy government bond, matched by currency and maturity to the cash flows being valued. The risk-free rate is the base input to the Capital Asset Pricing Model (CAPM), from which cost of equity is built, and is also embedded in the cost of debt through the credit spread a lender charges over the risk-free benchmark. Because it anchors both sides of WACC, an error in the risk-free rate propagates through the entire discount rate and the resulting valuation.

Beta

Beta is a measure of a stock's systematic risk — the portion of its return volatility that is correlated with movements in the broader market and cannot be diversified away. A beta of 1.0 moves in line with the market; a beta above 1.0 indicates higher-than-market sensitivity, and a beta below 1.0 indicates lower sensitivity. Beta is the key input to the Capital Asset Pricing Model (CAPM), which is used to estimate the cost of equity component of the discount rate in a DCF valuation. Beta can be sourced from a regression of a company's historical stock returns against a market index, or taken from published data services, and for private companies or specific projects is typically derived from a set of unlevered comparable betas re-levered to the subject's target capital structure.

Cost of Equity

Cost of equity is the rate of return equity investors require to compensate them for the risk of holding a company's stock, given its systematic risk relative to the broader market. It is most commonly estimated using the Capital Asset Pricing Model (CAPM), which expresses cost of equity as the risk-free rate plus a beta-adjusted equity risk premium. Cost of equity serves two roles in a DCF valuation: it is one of the two components blended into WACC (alongside the after-tax cost of debt), and it is used as the sole discount rate when valuing a levered cash flow (FCFE) directly.

Country Risk Premium (CRP)

The country risk premium (CRP) is an additional premium added to the cost of equity for cash flows or assets exposed to a specific country's sovereign or political risk, beyond the general equity risk premium applicable in mature, well-diversified markets. CRP is relevant whenever a DCF valuation involves cash flows exposed to a country carrying meaningfully higher sovereign risk than the base market used to estimate the equity risk premium, commonly proxied using sovereign credit default swap spreads, sovereign bond yield spreads over a risk-free benchmark, or published country risk ratings. CRP should be applied transparently and only once, since double-counting country risk (for example, in both the discount rate and the cash flow forecast) is a common and material valuation error.