Valuation · Cost of equity
Equity Risk Premium (ERP): Definition, Formula and Damodaran Estimates
The equity risk premium is the single most consequential assumption in any discounted-cash-flow model — a point of ERP moves the discount rate, and the discount rate moves every valuation that depends on it.
The equity risk premium (ERP) is the extra annual return investors require for holding stocks instead of risk-free government bonds. It is the compensation demanded for bearing equity risk — the chance that corporate earnings disappoint, markets fall, or a recession wipes out years of gains. ERP = Expected Market Return − Risk-Free Rate. In the United States the long-run realized premium has averaged roughly 4.5–5.5%, and it is the Rm − Rf term that sits at the heart of the CAPM cost-of-equity formula.
The ERP Formula, Step by Step
The equity risk premium is a difference, not a lookup value. You take what investors expect to earn on the broad equity market and subtract what they could earn with no risk at all. The gap is the premium:
- Long-run expected US equity return
- ~10.0%
- Risk-free rate (10-year Treasury yield)
- − 4.5%
- Equity risk premium (ERP)
- ≈ 5.5%
The 10% equity figure is the historical total return of the S&P 500 (price plus dividends) measured over many decades. The 4.5% risk-free rate is the current 10-year US Treasury yield — the benchmark for a default-free, dollar-denominated return. Subtracting one from the other leaves the ~5.5% of extra return investors have historically been paid for accepting equity risk. This is the number that flows into nearly every discount-rate calculation on the site.
Two things make ERP slippery. First, the “expected” market return is not observable — analysts proxy it with either long-run historical averages or a forward-looking implied estimate (below). Second, the choice of risk-free rate matters: most practitioners use the 10-year Treasury to match the long duration of equity cash flows rather than the near-zero-duration 3-month T-bill.
Damodaran's Historical & Implied ERP Estimates
The most widely cited source for the US equity risk premium is Professor Aswath Damodaran of NYU Stern, who publishes updated estimates on his website every month. His historical series going back to 1928 frames the premium two ways — a geometric average (compounded) and an arithmetic average (simple mean), which answer slightly different questions:
The implied ERP is the most defensible for live valuation work: rather than assuming the past repeats, it solves for the discount rate that makes today’s index price equal the present value of expected future cash flows — effectively the internal rate of return the market is currently pricing in. Because it is derived from live prices, Damodaran refreshes it at the start of every month, and it moves as interest rates and earnings expectations change. When you need a current number, use his monthly update rather than a hard-coded historical average.
How ERP Feeds Into CAPM
The equity risk premium is the engine of the capital asset pricing model. CAPM takes the market-wide premium and scales it by a stock's beta — its sensitivity to market moves — then adds the risk-free rate to produce that company's cost of equity:
- Risk-free rate (Rf)
- 4.5%
- Beta (β)
- 1.20
- Equity risk premium (ERP)
- 5.5%
- Beta-scaled premium (1.20 × 5.5%)
- 6.6%
- Cost of equity = Rf + β × ERP = 4.5% + 6.6%
- ≈ 11.1%
A stock with a beta of 1.20 is 20% more volatile than the market, so it earns 1.20 times the ERP on top of the risk-free rate. The full mechanics — beta sourcing, country and size adjustments, and when the model understates risk — are covered in the CAPM cost of equity guide.
How ERP Ripples Through WACC and DCF
The CAPM cost of equity is not the end of the chain — it is the equity component of the weighted average cost of capital (WACC). Because equity is usually the larger slice of the capital structure, a change in ERP moves WACC almost one-for-one with the equity weighting. WACC in turn is the discount rate applied to every projected cash flow in a DCF model, so the premium you choose touches the entire valuation, especially the terminal value years out.
The leverage is easy to underestimate. Consider a company whose free cash flows are discounted at a WACC built on a 5.5% ERP. Nudge the premium up by a single point to 6.5% and the discount rate rises by roughly a point too — which can cut the fair value estimate by 10–20% depending on how much of the value sits in distant terminal cash flows. A one-point ERP change is not a rounding error; it is often the difference between a stock screening as cheap or expensive. This sensitivity is exactly why the ERP assumption deserves more scrutiny than any other single input in the model, and why it is worth re-checking against Damodaran's current implied figure before trusting a valuation.
The 2024–2025 ERP Range and What Moves It
Across 2024 and into 2025 the implied US equity risk premium has sat in a band of roughly 3.5% to 6%, with most estimates clustering near the middle. The premium is not a constant — it compresses and expands with the macro backdrop. Three forces do most of the work:
- Rate expectations. ERP is measured against the risk-free rate, so the two are linked. When Treasury yields rise, investors can earn more with no risk, and — all else equal — the premium they demand for equities compresses. Falling yields do the reverse. Because yields climbed sharply in the 2022–2023 tightening cycle, much of the ERP conversation since has been about how much of the equity return is simply the higher risk-free base.
- Credit spreads and risk appetite. The premium widens when investors turn fearful. Blowouts in corporate credit spreads, spikes in the VIX, or a flight to quality all signal that the market is demanding more compensation for risk — pushing the implied ERP toward the top of its range. Calm, risk-on markets compress it toward the bottom.
- Earnings growth expectations. The implied ERP is backed out of expected future cash flows, so stronger forecast earnings growth lifts the premium the market is pricing in at a given index level, while downgrades to growth pull it lower. A richly valued index paired with modest growth expectations produces a thin premium — a recurring concern when the market trades at elevated multiples.
The practical takeaway: do not treat ERP as a fixed 5.5% forever. Anchor on the long-run historical average as a sanity check, but for a live valuation reach for Damodaran's current implied estimate and stress-test your conclusion across the plausible 3.5%–6% band.