What is the equity risk premium (ERP)?
To understand why there is an equity risk premium, you can make a simple comparison between a safe investment, such as a savings account, and a riskier investment, such as a share.
While the share promises the chance of a higher profit, it also harbors the risk of losses. The equity risk premium is basically the additional return that an investor requires on average to take on this risk of loss.
Put simply, the equity risk premium expresses the difference between the expected return on a risky investment on the stock market and the return on a risk-free investment.
In business valuation, the ERP is commonly referred to as the market risk premium (MRP) when it represents the premium for the market as a whole.
The ERP in the CAPM – significance for business valuation
The CAPM provides a formula for calculating a company’s cost of equity. These are made up of the risk-free interest rate and the company-specific risk premium.
- Risk-free interest rate: the return on a risk-free investment, such as a suitable government bond.
- Equity risk premium: the additional return investors expect for bearing systematic market risk.
- Beta factor: the company-specific measure of how strongly the return on a share moves in relation to the overall market.
The risk premium attributable to the company is therefore determined by multiplying the equity risk premium by the company’s beta factor. A high beta factor indicates greater sensitivity to market movements and therefore results in a higher required return, all else being equal.
The equity risk premium is therefore the market-wide price of systematic equity risk. It is a key parameter in the CAPM because it has a significant influence on the cost of equity. The higher the equity risk premium, the higher a company’s cost of equity.
The importance of the equity risk premium for business valuation is correspondingly high.
✅ For a broader explanation of the CAPM and its application in determining cost of capital, see our article on Cost of Capital in Business Valuation.
Determining the ERP – these are the methods
The equity risk premium cannot be observed directly. It therefore has to be estimated using market data and valuation models. The main approaches include historical and implied equity risk premiums. Surveys can also provide an indication of market expectations.
Each approach has advantages and limitations, and the appropriate method depends on the valuation purpose and available data.
1. The historical equity risk premium
The historical equity risk premium is calculated from the historical difference between the returns of a broad equity market index and a risk-free investment over a defined period.
For example, a calculation may compare the long-term return of a broad equity index with the return on a suitable risk-free investment. Different choices regarding the observation period, averaging method and risk-free benchmark can produce materially different results.
The principal advantage is that the calculation is based on observed market data rather than forecasts. However, historical returns do not necessarily represent current or future investor expectations. Structural changes in markets, interest rates, inflation, taxation and investor behavior can all affect the relevance of historical observations.
2. The implied equity risk premium
The implied equity risk premium is forward-looking. Instead of asking what investors earned historically, the approach asks what return is currently implied by market prices and expected future cash flows.
One established approach uses a dividend discount model (DDM): expected future dividends and other shareholder cash flows are discounted until the present value corresponds to the current market value of the equity. The implied market return can then be compared with the risk-free rate to derive the implied market risk premium.
✅ Our article Calculating the Market Risk Premium with the Dividend Discount Model (DDM) explains this approach in greater detail.
The advantage is that the implied ERP incorporates current market prices and forward-looking expectations. The disadvantage is that the result depends heavily on assumptions concerning future earnings, dividends, payout ratios and long-term growth.
Neither approach is universally superior. The historical ERP provides an empirical reference point, while the implied ERP provides a market-consistent, forward-looking perspective. Comparing both can therefore be useful when assessing whether a selected premium is plausible.
ERP – what valuation practice says?
There is no uniform, universally applicable equity risk premium in business valuation. Institutes such as the IDW and FAUB provide guidance for German valuation practice, but the appropriate assumption remains dependent on the valuation date, market environment and methodology.
A range of approximately 6% to 8% has often been used in German valuation practice as a reference range for the equity risk premium. This should not be interpreted as a mechanically applicable rate: the appropriate assumption needs to be supported by the relevant valuation framework and market conditions.
The reason for this variation lies in the complexity and uncertainty associated with determining the equity risk premium.
Several factors influence the appropriate assumption:
- Market conditions: changes in equity valuations, interest rates and volatility can affect expected returns.
- Risk-free rate: the ERP must be considered consistently with the selected risk-free rate and valuation date.
- Calculation method: historical and implied approaches can produce different results.
- Market definition: the selected equity market and currency must correspond to the valuation context.
- Economic expectations: long-term growth, inflation and profitability expectations affect forward-looking estimates.
- Valuation framework: the selected ERP must be consistent with the applicable valuation standard and methodology.
International experts such as Prof. Aswath Damodaran also regularly publish market-based estimates of equity risk premiums, providing an additional reference point for valuation professionals.
Practical application in business valuation
The equity risk premium should never be considered in isolation. It interacts directly with the risk-free interest rate and beta factor when determining the cost of equity.
A change in the ERP therefore affects the discount rate and, consequently, the present value of future earnings or cash flows. This effect can be particularly significant for companies whose value depends heavily on cash flows far in the future.
The selected ERP should therefore be documented together with its source, calculation method, valuation date and underlying assumptions. This makes the resulting cost of equity easier to reproduce, review and defend.
Conclusion – the equity risk premium in business valuation
The equity risk premium is central to business valuation. It reflects the additional return that investors demand for assuming systematic equity-market risk and has a significant influence on the cost of equity.
Determining the appropriate ERP is challenging because it cannot be observed directly. Historical approaches provide an empirical reference based on realized returns, while implied approaches derive a forward-looking premium from current market prices and expected cash flows.
In practice, there is therefore no single universally correct figure. A well-founded valuation considers the available market evidence, the chosen methodology and the specific valuation date, and documents why the selected equity risk premium is appropriate.
