Equity risk premium is quite popular among the modern ways of investment profits. ERP is related to the excess return that invested in the stock market over the risk-free rate. In other words, Equity Risk Premium is inspired by risk-reward tradeoff which considered as a rule where high-risk investments are remunerated with a higher premium.
Basic Formula for ERP
Equity Risk Premium = Expected total return on stocks – risk-free rate
This equation clearly indicates that ERP is directly proportional to the difference of expected total return on stocks and risk-free rate. The higher the difference b/w expected return and risk-free rate and hence a higher ERP. At least, one thing is clear that reward will be high for any investor who is willing to take higher risk.
If we take another look at this formula then you will realize that there are some calculations involved in calculating the Equity Risk Premium. First, we would have to calculate the total expected return on stocks and risk-free rate separately. After that, we would have to calculate the difference of both to get the ERP.
Steps involved in the Calculation of ERP
1. Expected Return on Stocks
2. Risk-Free Rate
3. The difference of expected return and risk-free rate to get overall equity risk premium.
Step 1: Calculate Expected Return (k)
Estimating the future stock returns on the stock is not impossible but very difficult though. Nevertheless, there are multiple ways to predict long-term stock returns which are as follows:
Dividend based approach tells that expected return will be equal to the dividend yield plus growth in dividends. However, earning based approach tells that expected return will be equal to earning yield.
Step 2: Risk-Free Rate
An investor always believes that the share of the company he/she have bought will bring value to him/her as the company grows increase in shares. However, there’s always the equal possibility of decreasing in value and shares. But, the truth is, that’s the risk every investor take to move forward. After all, we’ve already mentioned that potential reward is associated with higher risk. So, we can say that there is uncertainty in this. But, it’s not like that uncertainty will be everywhere. There is an asset which returns in the future with certainty. And the risk-free rate is defined as a rate of return where there is no risk in the investment.
The closest thing related to the safest investment and risk-free is the Treasury Inflation Protected Security (TIPS). Even though the prices vary with the interest rates so TIPS are not exactly risk-free.
Step 3: Difference between Expected Return and Risk-Free Rate
What left is to subtract risk-free rate (bond return) from stock returns to get the Equity Risk Premium (ERP).
As discussed above the equity risk premium can easily calculate by subtracting risk-free rate from estimated return on stocks. TIPS is a good example of Risk-Free but don’t believe that it would be entirely risk-free. Because there is no investment which doesn’t have a probability of loss. Nevertheless, TIPS can be considered as a standard. We believe this investment can bring some insights to you regarding the calculation of equity risk premium and guidance to various investors in the evaluation.