Equity risk premium is the excess expected return of a stock, or the stock market as a whole, over the riskfree rate. Under the riskreturn tradeoff, the more risk an investor is willing to accept, the more return he is going to expect for accepting that risk.
Equities can be a highrisk investment. Thus, if an investor is going to put his money into an equity, he will expect a risk premium over the alternative of a riskfree investment. Typically, U. S. Treasury securities are considered risk free because of the unlikelihood that the government will default on its obligations. Equities, on the other hand, have a greater risk of default because the company that issued the stock could have declining profit, or could go out of business.
The expected return from an equity must be calculated before calculating the equity risk premium. The expected return of an equity can be calculated two ways:
Under the earningsbased approach:
Expected Equity Return = Earnings per Share/ Stock Price
Under the dividendbased approach:
Expected Equity Return = (Dividend per Share/Stock Price) + Dividend Growth Percentage
Assume, using either of those two formulas, the expected return on an equity is 14%. If the U.S. Treasury bond rate is 6%, then the equity risk premium is 8%.
Equity risk premium = return on equity (14%) – riskfree rate (6%) = 8%
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