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Equity Risk Premiums (ERP): Determinants, Estimation and Implications

Aswath Damodaran

New York University - Stern School of Business

September 23, 2008

Equity risk premiums are a central component of every risk and return model in finance and are a key input into estimating costs of equity and capital in both corporate finance and valuation. Given their importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. In the standard approach to estimating equity risk premiums, historical returns are used, with the difference in annual returns on stocks versus bonds over a long time period comprising the expected risk premium. We note the limitations of this approach, even in markets like the United States, which have long periods of historical data available, and its complete failure in emerging markets, where the historical data tends to be limited and volatile. We look at two other approaches to estimating equity risk premiums - the survey approach, where investors and managers ar asked to assess the risk premium and the implied approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in non-equity markets. We close the paper by examining why different approaches yield different values for the equity risk premium, and how to choose the "right" number to use in analysis. (In an addendum, we also look at equity risk premiums during the market crisis, starting on September 12, 2008 through October 16, 2008.)

Number of Pages in PDF File: 77

Keywords: Equity Risk Premium, ERP, Implied Premium, Risk, Default spreads

JEL Classification: G10, G12, G30, G31, G00

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Date posted: October 1, 2008 ; Last revised: October 17, 2008

Suggested Citation

Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications (September 23, 2008). Available at SSRN: http://ssrn.com/abstract=1274967 or http://dx.doi.org/10.2139/ssrn.1274967

Contact Information

Aswath Damodaran (Contact Author)
New York University - Stern School of Business ( email )
Stern School of Business
44 West 4th Street
New York, NY 10012-1126
United States
212-998-0340 (Phone)
212-995-4233 (Fax)
HOME PAGE: http://www.damodaran.com
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