How the equity risk premium explains why shares should pay more
Shares are riskier than government bonds, so investors expect more from them. How much more is called the equity risk premium, or ERP. This page explains what the equity risk premium means, the ways to estimate it and why experts disagree on its size.
Quick answer
The equity risk premium (ERP) is the extra return that investors expect to earn from investing in shares instead of a risk-free asset like a government bond. It is the reward for taking on the higher risk of equities. It is a key input in CAPM and in estimating the cost of equity. Since it is an expectation, not an observed number, estimates vary.
Key takeaways
- ERP is the extra return expected from shares over safe bonds.
- It is the reward for bearing equity risk.
- It can be estimated from history, surveys or current prices.
- It feeds into CAPM and the cost of equity.
- There is no single correct ERP figure.
What is the equity risk premium?
If a government bond pays a certain return with almost no default risk, why would anyone buy shares, which can fall sharply? Only if shares are expected to pay more over time. That expected extra return is the premium for equity risk.
It reflects how much investors dislike the uncertainty of shares. When people are fearful, they demand a larger premium. When they are confident, they accept a smaller one.
How is it estimated?
| Method | How it works | Main weakness |
|---|---|---|
| Historical | Average past excess return of shares over bonds | Depends on the period chosen |
| Survey | Ask investors or experts what they expect | Opinions can be biased |
| Implied | Work back from current prices and expected cash flows | Depends on forecast assumptions |
The historical method looks at how much shares beat government bonds over many decades. The answer changes a lot depending on the start and end dates, and past results are not indicative of future results.
The implied method uses today's index level and expected earnings or dividends to find the return that justifies current prices, then subtracts the risk-free rate. Academic Aswath Damodaran publishes such estimates for many countries, including India.
Where is the equity risk premium used?
In CAPM, cost of equity = risk-free rate + beta x ERP. A higher premium raises the cost of equity, which lowers valuations in a DCF model. Small changes in the assumed figure can change a company's estimated value noticeably.
For emerging markets like India, some analysts add a country risk premium on top of a mature-market ERP to reflect extra risks such as currency swings and policy changes.
Why do experts disagree?
Because it is an expectation about the future, it cannot be directly observed. Different methods, time periods and assumptions give different answers. That is why reports often state the ERP they used, so readers can judge the result.
The premium also changes over time. It tends to rise in crises, when investors are nervous, and fall in calm, confident markets.
The key point to remember
The equity risk premium is the reward investors expect for owning shares instead of safe bonds. It is a central input in valuation, but it is an estimate, not a fact, and it does not promise that shares will beat bonds in any period.
Frequently Asked Questions
What is the equity risk premium?
It is the extra return investors expect from shares over a risk-free asset like a government bond, as a reward for higher risk.
How is the equity risk premium estimated?
It can be estimated from historical returns, from surveys of investors or experts, or implied from current market prices.
How is ERP used in CAPM?
In CAPM, the cost of equity equals the risk-free rate plus beta multiplied by the equity risk premium.
Is there an equity risk premium for India?
Analysts estimate one, often by adding a country risk premium to a mature-market figure. Estimates differ by source and method.
Does a positive ERP mean shares will always beat bonds?
No. It is an expectation over the long term, and shares can underperform bonds for long periods.
Disclaimer: Investments in the securities market are subject to market risks. Please read all related documents carefully before investing. This article is intended for informational and knowledge purposes only and should not be considered tax, financial, or investment advice. Tax laws and deductions may vary based on individual circumstances and regulatory changes. Readers are advised to consult a qualified tax advisor or financial professional before making any investment or tax planning decisions.
Indira Securities Private Limited (SEBI Reg. No.): NSE TM ID: 12866 | BSE TM ID: 663 | CDSL DPID: 17000 | SEBI Reg. No.: INZ000188930 | MCX TM ID: 56470 | NCDEX TM ID: 01277 | CDSL Reg. No.: IN-DP-90-2015 | CIN:U67120MP1996PTC085111 | RA SEBI Reg. No.: INH000023269 | IA SEBI Reg. No.: INA000021410 | SEBI Merchant Banking Reg. No.: INM000013536
