Investors expect higher returns to compensate them for taking greater risks. The equity risk premium is the expected extra return above the risk-free rate that investors anticipate for holding stocks and other risky assets. The equity risk premium is forward-looking, meaning it applies to future returns based on currently available information. You can assess whether the stock market is undervalued or overvalued by comparing today’s equity risk premium to historical averages. If the market’s implied risk premium is much higher than the historical average equity risk premium, then the market would appear overpriced.
Expected Market Returns
The stock market prices for stocks reflect an implied rate of return. You can estimate this expected market return from today’s stock market values and earnings estimates. The rate of return that discounts projected future earnings to today’s market price is the market return implied by today's prices. This calculation can be performed for individual stocks as well as for broad stock market indices like the Standard and Poor's 500. The expected rate of return calculated from a broad stock market index is called the market return.
The expected market return is higher than the risk-free rate. The additional return for holding equities is the equity risk premium. To calculate this premium for assuming additional risk, subtract the yield of the most appropriate fixed-rate Treasury security from the expected market return. Be sure to select the Treasury whose maturity is closest to the anticipated holding period of an equity investment.
Historical averages for equity risk premiums depend on the referenced historical period. Professor Aswath Damodaran noted how severely historical values have changed in his 2012 edition of "Equity Risk Premiums (ERP): Determinants, Estimation and Implications." According to Damodaran, 6 percent was the historical average for the ERP before the dotcom bust of the eaely 2000s. After the decade of 2000-2010, the historical average equity risk premium was closer to 4 percent.
Equity risk premiums that are lower than historical averages may indicate that the stock market is overpriced. Conversely, ERPs that are higher than historical averages may indicate that the stock market is under-priced. Investors should exercise caution in comparing historical and present risk premiums, however, because companies and economies face different challenges today than they did in the past.
Joe Escalada is a financial analyst. He earned a Master of Business Administration from the University of California at Davis and has passed all three Chartered Financial Analyst examinations. He has a bachelor's degree from the California Institute of Technology.