What Does
Equity Risk Premium Mean?
An equity risk premium (ERP) is the difference between the return on the market (cost of equity) and the risk-free rate. The ERP represents the extra return that investors demand over and above a risk-free rate to invest in an equity class.
Divestopedia Explains Equity Risk Premium
Equity risk premium is used to attract investors to commit their money to a particular project. The higher the percentage of the premium, the more risk involved in the investment. An equity risk premium is one of the many indicators that investors review before making an investment decision.
A common method to calculate ERP is to analyze the difference between the actual average historical returns earned investing in public stocks and the return on a risk-free investment. Based on historical empirical evidence, the typical cost of equity for businesses at various sizes and stages of the business life cycle can be summarized as follows:
- Blue-chip public companies: 8% – 15%
- Well-established large companies: 16% – 24%
- Mid-market companies: 25% – 34%
- Main Street companies: 35% – 45%
- Start-ups: 45%+
The equity risk premium is calculated as the risk-free rate less the cost of equity shown above. Some would argue that historical empirical evidence from the public stock market does not appropriately calculate the ERP in the private capital markets.