how to calculate equity risk premium
to calculate the equity risk premium we can begin with the capital asset pricing model capm which is usually written as ra rf a rm rf where so the equation for equity risk premium is a simple reworking of the capm which can be written as equity risk premium ra rf a rm rf if we are simply talking about the stock market a m then ra rm the beta coefficient is a measure of a stock s volatility or risk versus that of the market the market s volatility is conventionally set to 1 so if a m then a m 1 rm rf is known as the market premium and ra rf is the risk premium if a is an equity investment then ra rf is the equity risk premium if a m then the market premium and the equity risk premium are the same equity risk premium in realitythe equity risk premium isn t a generalizable concept even though certain markets in certain time periods may display a considerable equity risk premium economists argue that too much focus on specific cases has made a statistical peculiarity seem like an economic law several stock exchanges have gone bust over the years so a focus on the historically exceptional u s market may distort the picture this focus is known as survivorship bias 1the majority of economists agree though that the concept of an equity risk premium is valid over the long term markets compensate investors more for taking on the greater risk of investing in stocks the global equity risk premium historical average is 4 6 it is better in some countries than others e g 6 43 in australia and 6 38 in the u s the historical risk free rate has been lower than that for a little less than half of the last 60 years 23special considerationsthe equation noted above summarizes the theory behind the equity risk premium but it doesn t account for all possible scenarios the calculation is fairly straightforward if you plug in historical rates of return and use them to estimate future rates but how do you estimate the expected rate of return if you want to make a forward looking statement one method is to use dividends to estimate long term growth using a reworking of the gordon growth model k d p g