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Risk-Free Rate · Equity Risk Premium · ERP

The return on a risk-free investment (government bonds) and the equity risk premium above it — two key inputs to WACC.

Cost of Equity (Ke) = Rf + Beta × ERP
Valuation

What it is

Risk-Free Rate (Rf): The return an investor receives with zero default risk. In practice, the yield on 10-year US Treasury bonds is used.

Currently (2025–2026): Rf ≈ 4.3–4.5% — significantly above the 2009–2021 era (Rf 0.5–2%).

Equity Risk Premium (ERP): The additional return investors require for investing in equities above the risk-free rate. Compensation for volatility, uncertainty, and the possibility of loss.

ERP per Damodaran (current): ~5.0–5.5%

Cost of Equity (Ke) = Rf + Beta × ERP

Example (Microsoft): 4.4% + 0.9 × 5.25% ≈ 9.1%

Why a higher Rf = lower equity valuations: A higher risk-free rate raises WACC → raises the discount rate → lowers the present value of future cash flows → lowers DCF valuation. Mechanically: at Rf 1% and ERP 5%, Ke ~6%. At Rf 4.5% and ERP 5%, Ke ~9%. Same FCF projections, but 33% lower DCF value.

Why track it

The risk-free rate explains a large part of market valuation moves without any change in company fundamentals. The rate rise from 2021 to 2022–2023 caused a mechanical 30–60% decline in growth stock valuations — not because the businesses deteriorated, but because the discount rate rose.

Watch the US 10Y Treasury yield as macro context for valuations. Falling rates = tailwind for equity valuations.

Real-world example

Valuation compression 2021→2022:

  • Rf 2021: ~1.5%, Ke tech companies ~7–8%
  • Rf 2022: ~4.0%, Ke tech companies ~9–10%
  • DCF effect: tech stocks lost 30–50% despite unchanged fundamentals

Microsoft P/E: 35× (2021) → 23× (2026) — the dominant cause is the structurally higher risk-free rate, not a deterioration in the business.

Watch out for

ERP is not constant — it shifts with market sentiment. In panic (recession, financial crisis) ERP rises → equities become cheaper. In euphoria ERP falls → equities become more expensive. Damodaran's current ERP estimates are publicly available on his website (pages.stern.nyu.edu/~adamodar/).