DCF

The market risk premium

4 min read · updated July 2, 2026

The market risk premium is the extra return investors demand for putting money in the stock market instead of a risk-free government bond. It's the market's price of risk. Stocks can lose money; Treasuries basically can't, so nobody would hold stocks unless they paid more on average. That "more" is the market risk premium.

You'll hear it called the equity risk premium too. Same thing: the reward for bearing the risk of the whole equity market. In the formulas it shows up as $r_m - r_f$ , the market return minus the risk-free rate.

Where it sits in CAPM

It's the middle piece of CAPM:

$r_e = r_f + \beta \times \underbrace{(r_m - r_f)}_{\text{market risk premium}}$

Read that structure carefully, because it's the whole point. The market risk premium is the reward for holding the entire market. Beta then scales that reward up or down for one specific stock. A beta of 1.5 earns 1.5 times the market premium; a beta of 0.6 earns 0.6 times it.

Key insight

On any given day, the market risk premium (and the risk-free rate) is the same for every company you value. Beta is the only input that changes company to company. So when two firms have different costs of equity, beta is doing all the work, but the market risk premium sets the scale of the whole thing. Bump it a point and every company's cost of equity rises.

Why it runs about 5% to 7%

That's the range you should have in your head. Over the long run, US stocks have returned roughly 5 to 7 percentage points more per year than government bonds, and that historical spread anchors most estimates. It's not a law of nature, and it drifts, but if your market risk premium comes out at 2% or at 12%, something is wrong.

There are two main ways desks estimate it:

Historical: take the long-run average return of stocks and subtract the long-run average return of risk-free bonds. Simple, backward-looking.
Implied (forward-looking): back it out from today's market prices and expected cash flows, essentially solving for the premium that makes current valuations hold.

Most banks have a house number they use across every deal. The right move in an interview is to know the 5 to 7 percent range, not to invent your own figure on the spot.

Why the number matters

Because the market risk premium is multiplied by beta and feeds straight into the cost of equity, then into WACC, then into the discount rate of a DCF, a small change moves the valuation. Raise the premium by a point and every future cash flow gets discounted harder, so enterprise value falls. It's one of the quiet, high-leverage assumptions in a model, which is exactly why interviewers check that you respect it rather than treat it as a throwaway input.

Common mistake

The classic slip is confusing the market risk premium ( $r_m - r_f$ ) with the market return ( $r_m$ ) itself. The premium is the spread over the risk-free rate, not the total expected return on stocks. If someone hands you an expected market return of 9% and a risk-free rate of 3%, the premium is 6%, not 9%. The other common error is making up a number; anchor to the 5 to 7 percent range and use the desk's figure when you have one.

Interview tip

If asked "what's a reasonable equity risk premium," answer with the range and the reasoning in one breath: "Call it 5 to 7 percent, roughly the long-run spread of stocks over Treasuries, and I'd use the desk's house number in practice." Then, if you want to show real depth, add that it's the same across every company you value and that beta is what scales it. Crisp and correct beats a made-up precise decimal every time.

Glossary

New to the lingo? Every term used above, in plain English.

Equity risk premium (ERP): The extra return investors demand for holding stocks instead of risk-free government bonds. Historically it runs around 5% to 7%.
Risk-free rate: The return on an investment with essentially no risk, usually the yield on a long-term government bond. It is the starting point for the cost of equity.
CAPM (Capital Asset Pricing Model): The standard formula for cost of equity: the risk-free rate plus beta times the equity risk premium. It estimates the return shareholders demand for a stock risk.
Beta: A measure of how much a stock moves relative to the overall market. A beta of 1 moves with the market, above 1 is more volatile, below 1 is less. It feeds the cost of equity.
Cost of equity: The return shareholders require to own a company stock, given its risk. Usually estimated with CAPM, and it is always higher than the cost of debt.
WACC (Weighted Average Cost of Capital): The blended rate a company pays to fund itself with both debt and equity. In a DCF it is the discount rate used to bring future cash back to today.

Make it stick

Drill what you just learned

→