Equity Risk Premium

The equity risk premium is the extra return investors expect from the stock market as a whole above the risk-free rate. It pays them for holding stocks instead of government bonds. In CAPM, beta multiplies it to set a single stock's premium.

Estimates vary by source and method. Kroll recommends a 5.0% US equity risk premium, and Aswath Damodaran's implied premium for the S&P 500 ranged from 4.23% to 6.12% between 2015 and 2025. This site uses 5%, so a stock with a beta of 1.2 gets a 6% premium on top of the risk-free rate.

A higher premium raises every cost of equity estimate. Moving it from 5% to 6% lifts the example from 11% to 12.2%. The build-up method also starts with it before adding a size premium, and it sets the slope of the security market line. The CAPM guide discusses how to choose one.