Equity Risk PremiumCopy Anchor Link

Equity Risk PremiumCopy Anchor Link

The equity risk premium is the extra return investors demand, over the riskfree rate, for holding the average-risk equity investment. It is a central input to every cost-of- equity and cost-of-capital estimate, and therefore to every dcf-valuation. Damodaran's framing: "the expected return on any investment can be written as the sum of the riskfree rate and an extra return to compensate for the risk." The premium is "the premium that investors demand for the average risk investment, and by extension, the discount that they apply to expected cash flows with average risk."

There are three ways to estimate it, and they give different answers. The survey approach asks investors directly; the historical approach subtracts long-run bond returns from long-run stock returns; the implied approach solves backward from current market prices and expected cash flows for the required return. Damodaran is sharply critical of the historical default, which "remains the standard approach" but rests on fragile assumptions.

The historical premium has three failure modes he catalogues. The estimate swings with the time period, the riskfree-security choice, and arithmetic-vs-geometric averaging — "the risk premium estimated in the US markets by different investment banks, consultants and corporations range from 4% at the lower end to 12% at the upper end" from the same Ibbotson data. Short windows are too noisy to be useful, and the US is a survivor market: "the survivor bias will result in historical premiums that are larger than expected premiums for markets like the United States".

For markets outside the US, where histories are short and volatile, he prescribes a base premium plus a country risk premium — "Base Premium for Mature Equity Market + Country Premium" — with the country premium scaled by the volatility of that country's equities relative to its bonds.

His preferred answer is the implied premium, which requires no history and "reflecting current market perceptions". Its cost is that it assumes the market is correctly priced, and it moves far more over time than the historical number does.

Why the precision matters: the premium, multiplied through beta, is a large fraction of the discount rate, so a two-point error in the premium is a two-point error in the hurdle. This connects directly to risk-vs-uncertainty — the premium is the price the market attaches to bearing uncertainty, and mis-stating it is a systematic, not idiosyncratic, error. See valuation-across-asset-classes for how the same logic extends to country and asset- class risk.

SourcesCopy Anchor Link

• damodaran/markdown/riskprem.md
• damodaran/markdown/ERPfull.md
• damodaran/markdown/valuation.md