In this post, I want to follow up on the method to estimate the implied equity risk premium using the Finbox API function with an updated methodology, comparison with other market indices, and briefly discussing Damodaran’s numbers.
If you haven’t read my previous posts on the topic, feel free to check them out first:
- Implied Equity Risk Premium Estimate Using Finbox (link)
- S&P 500 Intrinsic Valuation Using Finbox (link)
Updated Methodology: Incorporating Net Income Growth Forecast
A key input for computing the implied equity risk premium is the earnings growth forecast for the next five years. The earnings growth serves as a base to estimate the potential dividends and buybacks firms can employ to return value to the shareholder in the coming years. The next five year growth is not a number you can find in a whitepaper or datasheet; it’s called a forecast for a reason.
In my previous article I proposed using Finbox’ Net Income Forecast CAGR 5Y (ni_proj_cagr_5y) as input for the earnings growth. The net income forecast is based on a bottom up estimate of growth for each of the S&P 500 firms. In total Finbox reports 6,283 estimates (April 4, 2020).
Finbox also offers a Net Income Growth Forecast (ni_proj_growth) metric which provides a forecast for the earnings growth in the next year. Incorporating this data in the model helps fine-tune the Year 1 growth. When discounting a series of cash flows, getting the “early money” right is important.
I kept the Year 5 earnings estimate consistent as to not dismiss the 5Y CAGR forecast input. For years 2 through 4, I split the difference between year 1 and 5 equally. The resulting calculation looks as follows:
The difference between the old methodology and new methodology is not that big: 6.64% (old) versus 6.61% (new).
Using Alternative Indices: STOXX 50, FTSE 250, CSI 100, S&P 100, Russell 1000
A question that comes up all the time when discussing the implied equity risk premium is: Why use the S&P 500 to calculate the risk premium? Why not any other index? What makes the S&P 500 so special that we can use it as the foundation to calculate the cost of equity in finance?
As Damodaran puts it in the 2020 edition of his paper on the equity risk premium: “Given its long history and wide following, the S&P 500 is a logical index to use to try out the implied equity risk premium measure”. In the section titled “Extensions of Implied Equity Risk Premium” (p110), Damodaran further expands on the topic of computing the equity risk premiums.
Out of curiosity, I used the same method on a couple of other well-known market indices. Below you can find the implied equity risk premiums as calculated on April 4, 2020.
- CSI 100 (CN): 8.78% (RMB 21T total market cap)
- FTSE 250 (UK): 8.81% (GBP 289B total market cap)
- S&P 100 (US): 6.73% (USD 15.32T total market cap)
- S&P 500 (US): 6.61% (USD 22.69T total market cap)
- STOXX 50 (EU): 8.41% (EUR 2.35T total market cap)
- Russell 1000 (US): 6.29% (USD 25.28T total market cap)
We can note two things.
First, the difference between the US stock market indices (S&P 100, S&P 500, Russell 1000) is not that large: 6.29% to 6.73% in favor of the larger market index. This can be explained by assuming the forward-looking estimate of the equity risk premium for small cap firms is -0.32% and for the large cap firms 0.12%.
Second, the difference between the US stock market indices and other indices is quite large (>2%).
This can potentially be explained by difference in risk-taking culture as “many companies and individuals in Europe have a cultural suspicion of risk-taking, entrepreneurialism and ‘Anglo-Saxon’ capital markets.“ Simply put, if you’re more risk averse you will demand a higher premium for investing in a more risky asset.
A second possible explanation is selection bias. Collectively, US companies are global leaders operating in a relatively free and open market with strong access to capital. The premium investors demand for a stake in a US company operating in this business environment is simply lower than for the same stake in any other market.
A third way to look at the difference is to consider that the markets may be overpriced (if the implied premium is too low) or underpriced (if the implied premium is too high). One could argue that the US and European equity market should be of equivalent risk, and therefore conclude that the European equity is underpriced (and may present an interesting investment opportunity).
Equity Risk Premium: Damodaran Versus Finbox API
Every month Damodaran updates the Implied Equity Risk Premium on his personal website. The Implied ERP on April 1, 2020, is 6.02%. Why are his numbers lower than the implied equity risk premium as computed using the Finbox API?
Before we get into the number crunching, let’s state the obvious and say that these are extraordinary times of economic uncertainty due to (1) the global coronavirus pandemic and (2) associated economics of stoppage, (3) the credit & funding market dislocations, and (4) the oil price wars.
Historically, the US equity risk premium averages around 4.5% (source: Damodaran’s Implied ERP (annual) from 1960 to Current) with peaks over 7% only occurring a handful of times in March 2009 (7.68%), April 2009 (7.01%), October 2011 (7.64%), January 2012 (7.32%), February 2012 (7.04%), and June 2012 (7.28%) (Source: Damodaran’s Implied ERP by month for previous months). The increased risk premiums were marked by market crashes: the financial crisis of 2007-08 and the European sovereign debt crisis of 2010.
Returning to the number crunching, a key difference between the two methods is the choice of inputs.
Input | Damodaran | Finbox API |
Cash flow | Dividend + buybacks | Dividend + buybacks – stock issuances |
Growth | Top down forecast | Bottom up forecast |
Payout Ratio | Sustainable | Sustainable |
In particular, the growth forecast is different. Damodaran’s analyst-acquired bottom-up estimate is 6.42% whereas the top-down estimate is 3.18%. Bottom-up estimates tend to over-estimate the growth as analysts focus in on specific firms and may not fully take into account the macro-environment. Sadly, there are no top-down estimates available through the Finbox API so the bottom-up forecast (weighted by net income) is the only option we have.
Also, the timing of the computation plays a role. Between March 12, 2020, and April 4, 2020, we tracked the implied equity risk premium using the old methodology resulting in an average of 6.75%, with minimum of 6.29% and maximum of 7.49%. Damodaran’s 6.52% falls within the range we’re seeing using Finbox.
Lastly, one of the limitations of the implied equity risk premium during a crisis is that while the index level and risk free rate are current, the earnings and cash flow numbers are stale. The trailing twelve months earnings will eventually come down as firms release their Q1 and Q2 reports. The index level has already “priced in” lower earnings whereas our model may not.
One way to work around this problem is to make the earnings growth forecast as current as possible. While Finbox updates the metric at least once a day for the most recent changes in analyst forecasts, they are still dependent on timely analyst forecasts.
Another workaround is by manual intervention and overriding the Finbox input with your own estimate of earnings growth. Matching Damodaran’s inputs (dividends + buybacks as cash flow choice, Year 1 earnings growth of -30%, 5Y CAGR of 1.47%, Adjusted expected cash payout of 87.86%) yields a lower, covid-adjusted implied equity risk premium of 5.54%.
At the end of the day, it’s up to everyone to determine which method they feel most comfortable with.
Date | IERP | S&P 500 | Riskfree | Market Cap | Earnings | Dividends | Buybacks | Issuances | Cash to Equity | Net Cash to Equity | Y1 Growth FC | 5Y CAGR FC | Sust. Payout |
---|---|---|---|---|---|---|---|---|---|---|---|---|---|
7/5 | 5.32% | $2,848.42 | 0.68% | $25,858,786 | $124.80 | $48.17 | $72.40 | $8.85 | $120.57 | $111.72 | -6.49% | 6.51% | 94.83% |
5/5 | 5.37% | $2,842.74 | 0.63% | $25,754,934 | $125.34 | $47.29 | $70.34 | $9.15 | $117.63 | $108.47 | -6.62% | 6.48% | 95.25% |
2/5 | 5.45% | $2,830.71 | 0.64% | $25,663,832 | $135.88 | $47.49 | $65.61 | $9.05 | $113.11 | $104.05 | -10.50% | 4.90% | 95.56% |
28/4 | 5.35% | $2,878.48 | 0.65% | $26,110,130 | $136.92 | $48.12 | $65.03 | $9.11 | $113.15 | $104.03 | -9.52% | 4.64% | 95.51% |
25/4 | 5.45% | $2,836.74 | 0.60% | $25,755,891 | $136.89 | $47.80 | $64.75 | $9.07 | $112.55 | $103.48 | -9.55% | 4.64% | 95.90% |
24/4 | 5.55% | $2,797.80 | 0.59% | $25,424,113 | $137.47 | $48.08 | $64.85 | $9.15 | $112.93 | $103.78 | -9.65% | 4.62% | 95.90% |
23/4 | 5.61% | $2,799.31 | 0.61% | $25,423,785 | $139.59 | $49.97 | $66.09 | $9.19 | $116.06 | $106.87 | -10.23% | 4.58% | 95.88% |
22/4 | 5.76% | $2,736.56 | 0.57% | $24,842,817 | $139.60 | $50.18 | $66.35 | $9.19 | $116.53 | $107.34 | -1.77% | 4.42% | 96.15% |
18/4 | 5.49% | $2,874.56 | 0.66% | $26,187,071 | $140.75 | $50.82 | $66.58 | $9.20 | $117.40 | $108.20 | -1.68% | 4.41% | 95.59% |
15/4 | 4.76% | $2,846.06 | 0.75% | $31,096,085 | $119.08 | $48.06 | $67.69 | $7.90 | $115.74 | $107.84 | 0.61% | 4.81% | 95.08% |
14/4 | 4.75% | $2,761.63 | 0.77% | $31,096,085 | $115.55 | $46.63 | $65.68 | $7.67 | $112.31 | $104.65 | 0.61% | 4.81% | 94.89% |
10/4 | 5.20% | $2,789.92 | 0.73% | $28,441,035 | $127.63 | $51.51 | $72.55 | $8.47 | $124.05 | $115.59 | 0.61% | 4.81% | 95.18% |
9/4 | 5.20% | $2,749.98 | 0.74% | $28,446,945 | $125.78 | $50.61 | $71.06 | $8.26 | $121.67 | $113.41 | 0.61% | 4.82% | 95.07% |
8/4 | 5.42% | $2,659.41 | 0.72% | $27,412,696 | $126.25 | $50.80 | $71.42 | $8.29 | $122.22 | $113.93 | 0.64% | 4.82% | 95.27% |
7/4 | 5.86% | $2,663.68 | 0.69% | $25,399,347 | $136.64 | $54.91 | $77.43 | $8.96 | $132.34 | $123.38 | 0.64% | 4.81% | 95.48% |
4/4 | 6.61% | $2,488.65 | 0.59% | $22,688,946 | $143.37 | $57.54 | $81.08 | $9.37 | $138.62 | $129.25 | 0.62% | 4.81% | 96.12% |
3/4 | 6.66% | $2,526.90 | 0.62% | $22,539,572 | $146.55 | $58.81 | $82.87 | $9.58 | $141.68 | $132.10 | 4.81% | 95.89% |
|
2/4 | 6.69% | $2,470.50 | 0.59% | $22,533,323 | $143.32 | $57.52 | $81.04 | $9.37 | $138.56 | $129.19 | 4.81% | 96.11% |
|
1/4 | 6.50% | $2,584.59 | 0.67% | $23,562,438 | $143.39 | $57.54 | $81.08 | $9.37 | $138.63 | $129.25 | 5.36% | 95.60% |
|
31/3 | 6.38% | $2,626.65 | 0.71% | $23,917,050 | $143.56 | $57.58 | $81.18 | $9.39 | $138.76 | $129.37 | 5.36% | 95.32% |
|
28/3 | 6.55% | $2,531.37 | 0.68% | $23,376,274 | $142.19 | $57.04 | $80.68 | $9.31 | $137.72 | $128.41 | 5.37% | 95.51% | |
27/3 | 6.29% | $2,630.07 | 0.85% | $23,968,209 | $143.51 | $57.57 | $81.43 | $9.39 | $139.00 | $129.60 | 5.37% | 94.39% | |
26/3 | 6.68% | $2,475.56 | 0.86% | $22,600,960 | $143.38 | $57.46 | $81.36 | $9.38 | $138.82 | $129.44 | 5.37% | 94.46% | |
25/3 | 7.13% | $2,447.33 | 0.86% | $21,340,638 | $150.09 | $60.32 | $85.59 | $9.89 | $145.91 | $136.02 | 5.64% | 94.33% | |
24/3 | 7.49% | $2,237.40 | 0.76% | $21,103,134 | $142.92 | $57.44 | $81.50 | $9.42 | $138.94 | $129.52 | 5.64% | 94.99% | |
21/3 | 7.18% | $2,304.92 | 0.89% | $21,160,519 | $142.92 | $57.44 | $81.50 | $9.42 | $138.94 | $129.52 | 5.64% | 94.13% |