Equity Risk Premium (ERP) and Required Return on Equity

The ERP is the amount of return required by an investor above and beyond the risk free rate, where the risk free rate is commonly the rate of return from a sovereign government bond with a maturity comparable to the investor’s time horizon.

Historical Estimates for ERP: this approach calculates the ERP based on historical returns of a stock market index above government bond returns over a sample period of time.

Analysts may adjust a historical ERP to remove biases that could be present in the sample.

Forward Estimates for ERP: this is an ex-ante approach where the ERP is based on current data about expected future returns.

Forward ERP estimates can be based on a Gordon Growth Model, macroeconomic statistical models, or a survey of experts.  Each technique has its own strengths and weaknesses.

Required Return on Equity

An investor’s required return on equity (or common equity as it is sometimes stated) is the total amount of return that an investor will demand in order to make the stock investment that is under consideration.  Generically, this amount reflects the risk free rate plus the appropriate equity risk premium.

Several methods for calculating the required return on equity will now be described.

Capital Asset Pricing Model (CAPM) and Beta

The CAPM model applies the risk free rate and a broad market equity risk premium, but goes on to make a security specific adjustment to the market ERP, called beta, based on the individual security’s sensitivity to broad market equity risk premium.

CAPM r common equity = r risk free + β * (ERPmarket)

Under CAPM, ERP is the broad market return minus the risk free rate of return.

When a stock is described as “high beta” this means the stock has a heightened sensitivity to changes in the value of the broader market.

A stock with a beta equal to one has returns that move in lock step with the broad stock market.

Beta (β) is commonly calculated from a least squares regression of the individual stock’s returns on the broad market index’s returns. CAPM is a form of a single factor regression model.

In valuing stocks an analyst is looking to the future; in respect for this the historical beta is often adjusted when determining the required return on equity.