What is the equity risk premium?

The equity risk premium (ERP) is the additional return that investors require for investing in stocks over risk-free government bonds. It compensates for the fundamental uncertainty of equity ownership: unlike bondholders who receive contractual coupon payments, equity holders are residual claimants whose returns depend entirely on future corporate earnings, which are inherently unpredictable.

The ERP can be measured backward-looking (historical) or forward-looking (implied). The historical ERP compares the average return of equities to the average return of Treasury bonds over long periods. Since 1926, US equities have returned approximately 7% more than Treasury bills and about 4-5% more than long-term Treasury bonds annually. The forward-looking (implied) ERP is extracted from current market prices using models such as the earnings yield minus Treasury yield approach or the dividend discount model.

The implied ERP is more useful for investment decisions because it reflects current market conditions. As of recent readings, the S&P 500 forward earnings yield (the inverse of the forward P/E) has been roughly 4.5-5.5%, and the 10-year Treasury yield has been approximately 4.0-4.5%, implying an ERP of only 0.5-1.5%. This compressed ERP suggests that stocks offer relatively little compensation above bonds, making the risk-reward proposition for equities less attractive than historical norms.

The ERP is a critical input for corporate finance and asset allocation. In discounted cash flow (DCF) models, the ERP sets the equity cost of capital and thus the discount rate for future cash flows. Lower ERP means lower discount rates, which justifies higher stock valuations. In portfolio construction, the ERP determines the relative attractiveness of stocks versus bonds. When the ERP is wide, the case for overweighting equities is strong. When it compresses toward zero, as it did in late 1999 and in 2024, the forward returns from equities relative to bonds tend to be disappointing, because investors are not being adequately compensated for equity risk.