What is the Equity Risk Premium?
Jason Voss, in the FT on 7th November 2011 described the Equity Risk Premium (ERP) as follows "the additional rate of return that investors require to compensate them for the risk of holding stocks as compared with holding a "risk-free" asset". The latter are Bills and Bonds, issued by governments. To calculate the ERP, Voss goes on to use the example of the United States:
ERP = earnings yield of S&P 500 - yield on 10-year US Treasury Note
Ideally, this should be a positive number. The earnings yield is calculated by dividing the earnings per share by the share price. If the ERP is negative, stocks may be overvalued, thus lowering the yield. The yield on the bond can be calculated by dividing the annual cash inflow by the current market price. This assumes the bond is held for a year and is difficult as prices are constantly changing.
Another metric used to examine this relationship is the Bond Equity Earnings Yield Ratio.