Equity Risk Premium

What It Is:

The equity risk premium is the difference between the rate of return of a risk-free investment and the rate of return of an individual stock over the same time period. Since all investments carry varying degrees of risk, the equity risk premium is a measure of the cost of that risk.

How It Works/Example:

Equity investors try to achieve a balance between risk and return. In theory, if a company is pursuing equity investment dollars, it must provide a premium to attract the equity investor.  For example, if an investor could earn a 5% return on a government bond (which would be considered a "no risk" investment), a company stock should yield a 5% return plus an additional return (the equity risk premium) in order to attract the investor.  If the stock yields a 12% return, in this example, the equity risk premium would be 7%. In practice, however, the price of a stock, including the equity risk premium, moves with the market. As a result, the investor uses the equity risk premium to look at historical values, risks, and returns on investments.

Why It Matters:

The equity risk premium is used in the capital asset pricing model (CAPM) to establish the valuation of invested shares in a diversified portfolio. For the business trying to attract capital, it may use a variety of tools to manage the market's expectations of the equity risk premium, such as stock splits and dividend yields.