Defining A Long-term Investment In The Stock Market

  • This “historical” premium approach yields 4.20% as the ERP for US unique boutique s in 2013, using data from 1928-2012. The other is to estimate an “implied” premium, by backing out an internal rate of return from current stock prices and expected cash flows. Replacing the current implied equity risk premium with the average premium over the last decade (4.71%) yields a level of almost 1800 for the index, and using the analyst-estimated growth rate will make it even higher. Second, the cash returned in 2012 may have been a historic high in dollar value terms, but as a percent of the index, it is close to the average yield over the last decade. You may have very different views on the market drivers and if you are interested, you can input your numbers into the attached spreadsheet to get an assessment of value for the S&P 500 index. Third, the aggregate cash balances at the S&P 500 company amounted to 10.66% of firm value at the end of 2012, suggesting that companies have cash on hand to sustain and perhaps even increase cash returned to stockholders. Over the last 5 years, the compounded average annual growth rate in aggregate earnings for the S&P 500 has been 4.42%. As the most widely followed index in the world, analyst estimates of growth in earnings are widely available both for individual companies in the S&P 500 index and for aggregate earnings in the index.

     

    In fact, the average implied ERP over the last decade has been 4.71%, lower than the current implied ERP. Based upon my assumptions, the market’s current winning ways can be justified. I have an long, not-very-fun update that I do on equity risk premiums that you can download and peruse, if you are so inclined. Higher risk free rates have a negative, albeit muted, effect on value, if accompanied by higher growth rates, but do have a much more negative impact, if growth rates remain unchanged. I think that the most likely scenario is that the interest rates will rise as the economy improved, and the outlook for stocks will depend in large part on whether earnings growth picks up enough to offset the interest rate effect. “We remain optimistic and expect another year of double-digit gains as the economy and society slowly transition back to normal,” he said. While that growth can be estimated by looking at history or by tracking analyst forecasts of earnings for the individual companies, it has to be earned by companies, reinvesting their earnings back into operations and generating a healthy return on equity on those investments. Using the former to construct a bottom-up estimate of growth yields 10.57% as the expected growth rate in March 2013. Since there is evidence that analyst estimates of growth are biased upwards at the company level, we also looked at the “top down” estimates of growth that analysts are forecasting for aggregate earnings in March 2013, obtaining a lower growth rate of 5.33% a year for the next 5 years.

     

    While this number is lower than the top-down analyst estimate of growth, it is within shouting distance of the estimate. If economic growth translates into earnings growth, neutral. Background: For dividends and buybacks to continue to grow in the future, there has to be growth in earnings. If it is, then the equity reinvestment rate and ROE are both over stated, and the expected growth rate will be lower. One way to check is to compute the intrinsic growth rate by computing the equity reinvestment rate and return on equity for the index. In most small caps there is one big rally and then they exhaust themselves. It is determined on the one hand by perceptions of the macro risk that surround investors, with greater risks going with a higher ERP, and on the other hand by the collective risk aversion of investors, with more risk aversion translating into a larger ERP.

     

     

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