Equity Risk Premium = 1/PE ratio minus the 10yr Bond Yield. Also known as the Stock Risk Premium, it measures the expected additional return an investor earns by holding the riskier stock market rather than government bonds. Finesse calculates it by subtracting the 10-year government bond% yield from the current stock market earnings % yield. The stock market earnings % yield is the inverse of the price-earnings PE ratio (i.e., 1/PE). The PE rises as the stock market becomes over-valued. This causes the earnings yield and the Equity Risk Premium to drop, making the bond yield more attractive. So, the Equity Risk Premium rises as the stock market value decreases or as bond yields decrease, and the higher the premium, the better. The Equity Risk Premium can also be based on historic stock market returns or by polling stock analysts, but Aswath Damodaran, NYU School of Business, suggests these are unreliable and that the current implied premium based on the current PE ratio has a higher correlation with actual stock market returns over 1, 5, and 10 years out. See Table 26, pg. 128 of his paper “Equity Risk Premium: Determinants, Estimation, and Implications – the 2021 Edition,” updated March 21, 2021. He cautions that it is important that the same method be used consistently over time and across countries as Finesse does with the formula described above.
