Equity Risk Premium

Think of the Equity Risk Premium, as a hurdle rate required in order to assume the extra risk involved in investing in stocks. The premium demand for stocks will depend on the current phase of the Equity Cycle.

In order to justify the extra risk over and above the return offered on a “Risk-Free” Investment, a return premium is required. This is the Equity Risk Premium justifying the extra risk involved in investing in the Stock. The Risk Premium allocated to a Stock, then added to a risk-free rate of return, should over the long-term, indicate the possible return of a Stock. The estimated level of risk specific to a stock, earnings forecasts, price volatility, and valuations will be factors in determining the specific excess Equity Risk Premium for an individual Stock. Therefore, the premium demanded will vary depending on the Equity Cycle and outlook for a specific Stock.