What are the main methods for estimating the equity risk premium and which should I use?

Question

AcadiFi · Accepted Answer

The equity risk premium (ERP) is arguably the most important and most debated input in equity valuation. It is the extra return investors demand for holding equities over risk-free assets.

**Method 1: Historical Average**

$$
ERP = 	ext{Average equity return} - 	ext{Average risk-free return}
$$

Using long-run data (e.g., 1926-2025 for the US):
- Geometric mean: ~5.5-6.0%
- Arithmetic mean: ~7.0-8.0%

**Issues:**
- Very sensitive to the time period chosen
- Geometric vs. arithmetic creates a ~2% difference
- Survivorship bias (we study the US because it survived and prospered)

**Method 2: Gordon Growth Model (Forward-Looking)**

$$
ERP = \frac{D_1}{P_0} + g - r_f
$$

Using current market data:
- S&P 500 dividend yield: ~1.5%
- Expected earnings growth: ~5.0%
- Expected buyback yield: ~2.0%
- Implied equity return: ~8.5%
- 10-year Treasury yield: ~4.2%
- **Forward ERP ≈ 4.3%**

**Method 3: Survey-Based**

Ask practitioners and academics for their ERP estimate. Results typically range:
- CFOs: 3.0-4.0% (tend to be lower)
- Academics: 4.5-6.0%
- Investment professionals: 4.0-5.5%

**Method 4: Macroeconomic Model (Supply-Side)**

$$
ERP = [\frac{1 + E(i)}{1 + \Delta(PE)} - 1] + E(g) + E(	ext{Income}) - r_f
$$

Builds ERP from economic fundamentals: inflation, real growth, yield, and repricing.

**Comparison Table:**

| Method | Typical Range | Advantage | Disadvantage |
|---|---|---|---|
| Historical | 5.5-8.0% | Empirical, long track record | Backward-looking, period-sensitive |
| GGM (Forward) | 3.5-5.0% | Uses current market data | Assumes market is correctly priced |
| Survey | 3.0-6.0% | Captures practitioner beliefs | Subjective, anchoring bias |
| Macro Model | 3.5-5.5% | Theoretically grounded | Complex, many inputs |

**Practical Implications:**

A 2% difference in ERP dramatically changes valuations. Using the GGM on a stock with g = 4%:

| ERP | r (assuming rf = 4.2%, beta = 1.0) | V0 = D1/(r-g) with D1 = $3.00 |
|---|---|---|
| 4% | 8.2% | $71.43 |
| 6% | 10.2% | $48.39 |
| 8% | 12.2% | $36.59 |

The stock's value nearly halves when ERP doubles from 4% to 8%.

**Exam Tip:** CFA Level II often asks you to identify which ERP estimation method is most appropriate given a specific context. If they describe using long-run historical data, mention survivorship bias and time-period sensitivity. If they use a GGM approach, note it's forward-looking but assumes current prices are informationally efficient.

Study ERP estimation techniques in our CFA Level II equity valuation course on AcadiFi.

What are the main methods for estimating the equity risk premium and which should I use?

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