How do I calculate the Gordon growth model implied ERP?

Question

AcadiFi · Accepted Answer

The Gordon (constant-growth dividend discount) implied ERP uses current market prices and forward dividend expectations to back out the required return, then subtracts the risk-free rate.

Gordon growth model:
Price = D1 / (ke − g)

Rearranged for ke:
ke = (D1 / Price) + g

Implied ERP:
ERP = ke − Rf

Step-by-step for S&P 500 at start of 2026:

Inputs:
- S&P 500 level: 5,840
- 2026E dividends per index unit: $82
- 2026E buybacks per index unit: $96 (important to include)
- Total cash yield = ($82 + $96) / 5,840 = 3.05%
- Long-run growth estimate g = nominal GDP growth ≈ 4.25% (2.25% real + 2.0% inflation)
- Rf = 4.25% (10Y Treasury)

ke = 3.05% + 4.25% = 7.30%
Implied ERP = 7.30% − 4.25% = 3.05%

This looks low — let's refine with a two-stage model.

Two-stage implied ERP:
Stage 1 (years 1-5): high growth phase using analyst estimates (e.g., 6% cash flow growth)
Stage 2: terminal growth at 4.25% in perpetuity

Solve for ke that makes PV of cash flows equal 5,840:

Using iterative solver (Excel Goal Seek), if stage 1 growth is 6% and stage 2 is 4.25%, ke ≈ 8.2%, giving ERP ≈ 3.95%.

Practical considerations:
1. Include buybacks — they're a huge portion of total shareholder yield
2. Use forward dividends (D1), not trailing (D0 × (1+g))
3. For multi-stage, use analyst consensus for first 5 years
4. Sensitivity-test growth assumptions: implied ERP is extremely sensitive to g

Typical implied ERP results:
- 1990s: 2-4% (often criticized for being too low given bubble)
- 2000s: 3-5%
- Post-GFC: 5-7%
- Current (early 2026): 3-5% depending on model

Damodaran publishes implied ERP monthly. His current estimate is around 4.5% using implied ERP with buybacks and two-stage growth.

Strength: forward-looking, reflects current market pricing.
Weakness: sensitive to growth assumptions; can flip quickly with rates.

How do I calculate the Gordon growth model implied ERP?

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