Equity Risk Premium (ERP) represents the additional return investors demand for holding equities over risk-free assets, compensating for the higher risk associated with investing in equity and reflecting the uncertainty and volatility of stock markets. Therefore, ERP plays a vital role in financial decision-making due to its widespread use in valuation models, capital budgeting, and portfolio management. 

A qualitative analysis of ERP is particularly relevant given investor concerns about market overvaluation, sustained geopolitical tensions, technological advancements, economic uncertainty, and inflationary pressures in developed markets. These factors suggest that historical excess returns from Indian markets may not fully represent future expectations.

In this report, we have studied ERP in India using two approaches – Historical and Forward-looking with a cut-off date of 31 December 2024. This publication emphasises the need for an adaptable and forward-thinking approach to ERP analysis. It reviews historical data and offers insights into future projections, considering current market dynamics and potential risks. This study represents a step towards enhancing our understanding of the forces that affect the cost of equity and aims to be a valuable resource for valuation professionals, financial analysts, policymakers, academics, and investors.

Estimating the cost of equity

While the cost of equity can be estimated using multiple tools, the Capital Asset Pricing Model (CAPM) is by far the most popular. A key input to the CAPM is ERP, which represents the excess return that investing in the stock market provides over a risk-free rate.

While various techniques have evolved over time to estimate the ERP in a given market, we have used two of the most commonly and internationally accepted approaches, i.e., the historical estimate approach and the implied estimate (forward-looking estimate) approach to estimate ERP for the equity markets in the Indian economy.

Historical estimate approach

Historical analysis indicates that the Indian stock market gave an average annualised return of 15.2% during 2001–2024 for different investment horizons. This implies an excess return of 7.6% over the risk-free rate.

To refine this estimate, we adjusted the excess return for the return generated due to expansion in valuation multiples. Considering that valuation multiples cannot keep expanding perpetually in a developed or efficient equity market, we arrived at an adjusted excess return of 5.1%. We then applied equal weightage to excess returns, both with and without the adjustment for multiple expansions to calculate the ERP under the historical approach.

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Implied estimate (Forward-looking estimate) approach

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On a forward-looking basis, we estimated the return expectation priced in the current market index. Return expectation was calculated at a rate at which the present value of future expected cash flows of constituent companies of the Nifty 50 index equals the weighted market cap of the index. This analysis indicates that investors expect a market return of 13.8% based on forecasted future earnings growth, implying an excess return of 7.0%.

We considered a risk-free rate of 6.79% as of 31 December 2024, based on the 10-year zero coupon yield as published by the Clearing Corporation of India Ltd. (CCIL). Beta for the market portfolio was considered at 1.0 to calculate the long-term ERP for India under the forward-looking approach. This method gave an estimated ERP = 7.04%.

ERP, as estimated using the forward estimate approach, is based on the risk-free rate prevailing as of the cut-off date of 31 December 2024. While a minor change in the risk-free rate should not impact the fundamental expectation as arrived at under this approach, any significant change in the risk-free rate may lead to a material change in the ERP expectation, thereby requiring re-estimation.

Manish Saxena, Partner, Valuations, Grant Thornton Bharat
As we continue to witness economic disruptions, the need for an adaptable and forward-thinking approach to ERP becomes even more pressing. Our study not only reviews historical data but also offer insights into future projections, taking into account the current market dynamics and potential risks and represents a step towards enhancing our understanding of the forces that shape the cost of equity.
Manish Saxena Partner, Valuations, Grant Thornton Bharat

Conclusion

We have calculated ERPs using the Historical and Forward-looking approaches and based on the arithmetic mean of ERPs thus estimated, we believe that an ERP (rounded) of 6.75% can be considered a reasonable premium for investing in the Indian equity markets. This dual approach helps provide a balanced view, considering past performance and future expectations.

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Equity Risk Premium Study

March 2025

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