What is an Equity Risk Premium?
The equity risk premium is the difference between the rate of return of a risk-free investment and the geometric mean return of an individual stock over the same time period. Since all investments carry varying degrees of risk, the equity risk premium is a measure of the cost of that risk.
How Does an Equity Risk Premium Work?
Equity investors try to achieve a balance between risk and return. In theory, if a company is pursuing equity investment dollars, it must provide a premium to attract the equity investor. For example, if an investor could earn a 5% return on a government bond (which would be considered a 'no risk' investment), a company stock should yield a 5% return plus an additional return (the equity risk premium) in order to attract the investor. If the stock yields a 12% return, in this example, the equity risk premium would be 7%. In practice, however, the price of a stock, including the equity risk premium, moves with the market. As a result, the investor uses the equity risk premium to look at historical values, risks, and returns on investments.
Why Does an Equity Risk Premium Matter?
The equity risk premium is used in the capital asset pricing model (CAPM) to establish the valuation of invested shares in a diversified portfolio. For the business trying to attract capital, it may use a variety of tools to manage the market's expectations of the equity risk premium, such as stock splits and dividend yields.