Equity risk premium

The equity risk premium is the difference between the expected rate of return on shares (collectively) and the risk free rate of return. It is the amount of extra return investors demand for taking the extra risk involved in investing in shares.

The concept of the equity risk premium is central to the valuation of shares, and to using CAPM in particular.

Estimating the equity risk premium is fairly tedious and uncertain. It involves working backwards from market profit growth forecasts and current share prices to the equity risk premium this implies. This is sufficient for valuing shares against the market.

It is also worth comparing the current equity risk premium to historical values and considering whether it may be too high or low, implying that the market as a whole is under-valued or over-valued respectively. In estimating historic values of the equity risk premium it is usual to assume that the actual market returns (up to now) are the returns that were expected.

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