Equity Risk Premiums (ERP): Determinants, Estimation and Implications - The 2023 Edition

143 Pages Posted: 3 Apr 2023

See all articles by Aswath Damodaran

Aswath Damodaran

New York University - Stern School of Business; New York University (NYU) - Leonard N. Stern School of Business

Date Written: March 23, 2023

Abstract

The equity risk premium is the price of risk in equity markets, and it is not just a key input in estimating costs of equity and capital in both corporate finance and valuation, but it is also a key metric in assessing the overall market. Given its importance, it is surprising how haphazard the estimation of equity risk premiums remains in practice. We begin this paper by looking at the economic determinants of equity risk premiums, including investor risk aversion, information uncertainty and perceptions of macroeconomic risk. In the standard approach to estimating the equity risk premium, historical returns are used, with the difference in annual returns on stocks versus bonds, over a long period, comprising the expected risk premium. We note the limitations of this approach, even in markets with an abundance of data, like the United States, 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 are asked to assess the risk premium and the implied premium approach, where a forward-looking estimate of the premium is estimated using either current equity prices or risk premiums in other markets. In the next section, we look at the relationship between the equity risk premium and risk premiums in the bond market (default spreads) and in real estate (cap rates) and how that relationship can be mined to generate expected equity risk premiums. 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.

Keywords: Equity Risk Premium, Cost of equity, Cost of capital, Risk, Price of risk

JEL Classification: G12, G31

Suggested Citation

Damodaran, Aswath, Equity Risk Premiums (ERP): Determinants, Estimation and Implications - The 2023 Edition (March 23, 2023). Available at SSRN: https://ssrn.com/abstract=4398884 or http://dx.doi.org/10.2139/ssrn.4398884

Aswath Damodaran (Contact Author)

New York University - Stern School of Business ( email )

Stern School of Business
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United States
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HOME PAGE: http://www.damodaran.com

New York University (NYU) - Leonard N. Stern School of Business ( email )

44 West 4th Street
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New York, NY NY 10012
United States

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