Why aren’t markets around the world crashing to historical lows amidst the global pandemic? In this blog post I take a closer look at the factors driving market valuation and discuss whether the markets are delusional or rational.
On February 19, the S&P 500 index reached a new all-time high of 3386.15. One month later, on March 23, the same index stood 34% lower at 2237.40. All gains since January 2017 wiped out due to the COVID-19 induced fear and uncertainty. Today, April 29, the S&P 500 sits around 2800, still down from it’s peak right before the crisis but far from the market crash everyone seems to be talking about.
The question on some people’s minds seems to be: when will the market eventually crash? Other people claim the earnings headwind is already priced in. Using the DCF method, I value the S&P 500 index and look at the data to try and make sense of this question. I cover three main inputs to value the S&P 500:
- Equity risk premium: is the implied equity risk premium unusually low or high?
- Earnings forecast: is the expected growth in future cash flows reasonable?
- Payout ratio: are the expected returns reasonable?
Implied Equity Risk Premium
The equity risk premium is the price of risk in equity markets. It can be understood as the premium investors demand for investing in an equity asset. The riskier an asset, the higher the associated risk premium will be.
Although no asset is truly risk free, we could argue that government bonds from first world countries like United States or Germany are risk free in practice because their governments will never default. Similarly, you’ll find that the risk premium for well-established firms in mature markets will be lower than the premium for startups in developing markets.
In valuation and corporate finance, the equity risk premium is an essential input for calculating the cost of equity and cost of capital. Traditional methods employ a backwards looking historical equity risk premium. In modern valuation we prefer to use a forward-looking implied equity risk premium.
The implied risk premium is estimated using current market data such as market capitalization and risk-free rate, and most recently available company earnings reports. In this blog post I outline how to perform the calculation using tools provided by the online data service Finbox.
Historical Perspective
Since my first blog post on how to use Finbox to estimate the implied equity risk premium, I’ve been tracking the implied equity risk premium of a variety of major indices. Below you can find the updated visualization.
As you see in the chart above, the implied equity risk premium for the S&P 500 decreased from near 8% at the end of March to 5.5% at the end of April. I discussed a variety of elements influencing the equity risk premium calculation in times of crisis in a follow-up blog post earlier this month. If you’re interested, I would definitely recommend going through that blog post.
According to Damodaran’s research, historically the equity risk premium for the S&P 500 averages around 4.5%. This is substantially lower than today’s 5.5% to 6.0%. If we consider only the years since the 2007-2008 financial crisis, the historical risk premium hovers around 5% to 6%. Today’s risk premium falls within this range perfectly.
Future Cash Flows
An crucial input to value the S&P 500 is the expected future growth of cash flows. There are a variety of methods to determine this input. You can rely your own expertise to estimate the growth every year. Of course, you can also rely on the forecasts of the managers of the firms you’re tracking. You can also ask analysts to provide estimates. You can use a top-down approach and estimate the growth for the index as a whole, or a bottom-up approach by estimating the growth of each company in the index to derive the overall growth of the index.
In my blog post titled Finbox Implied Equity Risk Premium Follow-Up I outline a particular method of estimating the growth of future cash flows using Finbox. There are two key inputs:
- For each company in the index, the expected growth in net income in the first year
- For each company in the index, the expected compound annual growth rate of net income for the next five years
The growth estimates are provided by industry analysts and aggregated by Finbox. In the charts below you can find the estimates over time.
As you can see, the analyst estimates are slower to adjust to the crisis than the market. One would hope that is the case! The market can be irrational and emotional, but we need analysts to help us make sense of the situation and provide careful, well-founded and rational insight.
Since about a week or so, we see that the analysts have started putting a figure to the impact of the virus. Estimates for Western markets range from near -20% (Europe and UK) to -10% (United States). For China and Japan, the situation is slightly different, and in particular the Chinese situation is an interesting topic (which I will cover in a future blog post).
The bottom-up analyst outlook for the next 5 years remains relatively stable for all markets. The forecast slightly more favorable for the US and European companies and hovers around 4-5% CAGR.
Sustainable Payout Ratio
The last input we need for our discounted cash flow model is the expected return of the excess cash flows generated by the firm to the shareholders. This topic addresses the dividend decision in corporate finance. Simply put, it poses the question whether the excess returns will be reinvested in the firm or returned to the shareholders.
In theory, a company aims to maximize shareholder wealth. If the company has interesting and highly profitable projects lined up, then reinvesting excess returns into those projects is preferred. However, if the company has no interesting projects then the company should return the cash to the shareholders such that the shareholders can invest it in other companies that may have interesting projects.
There are two ways companies can return cash to the shareholder: dividends and buybacks. Each method has its advantages and disadvantages, and it’s up to the management of the company to determine what’s best for their situation. Collectively, we can capture the returns to the shareholders as a Payout Ratio. The payout ratio for the S&P 500 currently sits around 88%. That means for every $100 in net earnings, S&P 500 firms return $88 to the shareholders.
In this discounted cash flow model, we employ a sustainable payout ratio based on the stable growth rate after year 5 and the trailing twelve months return on equity.
We can argue at length whether it is reasonable to assume companies will eventually return to the shareholder every dollar they can’t reinvest (and whether the cash that gets reinvested actually creates value for the shareholder), but what we all assume is that the payout ratio is a decision made by the company management. The management is accountable to the shareholders, and this dynamic ensures the payout ratio will be reasonable considering the company’s performance. If the payout ratio would be impacted by external forces, e.g. government mandating a maximum payout ratio of 70%, then the value of the index would drop very rapidly.
Bringing It All Together
Let’s bring together the different inputs.
- At 5.5%, the implied equity risk premium for the S&P 500 is higher than the historical equity risk premium for US equity markets, but sits right in the middle if we consider the risk premium since 2008.
- At -9.52% for the next year, the Finbox aggregated analyst earnings forecasts for the S&P 500 firms are quite downbeat. This reflects a major impact of the coronavirus on supply and demand.
- The sustainable payout ratio assumes companies will return excess returns to shareholders if management does not have interesting projects to invest in
Based on the findings above, it certainly looks like investors are making a reasonable attempt at valuing the market. The equity risk premium implies investors don’t find stocks any riskier than they were pre-crisis. The earnings forecasts that drive the discounted cash flow model are not implying a straight up catastrophe, but are definitely downbeat. Lastly, the payout ratio implies investors expect firms will return cash to the shareholders reasonably.
Of course, the above is merely my opinion. Perhaps you find equity risk greatly underestimated, or find the analyst forecast too positive considering the circumstances, or expect payouts to substantially change in the coming years. In the table below I’ve added a couple of scenarios to value the S&P 500 with different assumptions.
| Equity Risk Premium | Y1 Growth Forecast | 5Y CAGR Forecast | Sustainable Payout Ratio | S&P 500 Valuation |
| 5.41% | -9.52% | 4.64% | 95.89% | 2863.32 |
| 7% | -9.52% | 4.64% | 95.89% | 2190.51 |
| 5.41% | -20% | 4.64% | 95.89% | 2834.18 |
| 5.41% | -9.52% | 1.00% | 95.89% | 2439.10 |
| 5.41% | -9.52% | 4.64% | 75.00% | 2285.78 |
Also, you can use the excel document below to experiment yourself. It contains the latest data on April 29, 2020, as provided by Finbox API. Simply adjust the assumptions on the last sheet and see how the intrinsic value estimate changes.
(PS: the answer to the question whether markets today are delusional or rational is of course that they are both and neither at the same time *wink*)