The equity risk premium is a common measure for screening stocks:
Equity Risk Premium = Forward E/P – 10-year Treasury Yield
The U.S. Treasury Yield is said to be that for a risk-free investment. (The U. S. government has never defaulted on its debt…..though, with the accumulated deficits now, we are getting worried!). So, the equity risk premium measures the added risk for equities, the yield for taking on equity risk over the risk-free rate (or so it is said). So, if the E/P is low relative to the risk-free rate, the screen says that maybe the market is underpricing the risk in stocks.
This, like the other screens in chapter 2, is simple but too simple! E/P, the reciprocal of the P/E ratio, prices expected growth as well as the risk to growth. So a firm with a low E/P (high P/E) looks less risky but it could be one with high growth with less risk.
The equity risk ratio is most commonly applied as a screen for the stock market as a whole. In the late 1990s, Alan Greenspan, Chairman of the U.S. Federal Reserve, claimed the stock market was overvalued due to “irrational exuberance.” The comparison is sometimes called the Fed Model of valuation. He might have been right but pointing to the market’s E/P ratio relative to the 10-year Treasury Yield as evidence is suspect. Stocks imbed expected growth, but bonds have no expected growth. So (again) the market’s E/P can be lower than the bond yield because expected growth is priced in. Put another way, the bond yield is a yield over several years to maturity, but the forward E/P is an earnings yield for just one year ahead, not over the many future years (to an indefinite maturity date). Over those future years, stocks can deliver more earnings (growth).
In January 2025, the forward E/P for the S&P 500 dipped below the 4.6% yield for the U.S. Treasury bond: The equity risk premium was -0.15. Was the market overpriced or priced with expected growth? The S&P was dominated by large tech firms…the so-called Magnificent Seven…with growth potential beyond the earnings one year ahead in the E/P ratio. That said, these stocks could well be overpriced, but the equity risk premium is a suspect indicator.
(There is a case where the Fed Model works: If all growth is risky so that the E/P ratio just indicates risk. The Fed Model Case in the Case Book takes you there.)