Markets Aren’t Crashing? (S&P 500 Valuation)

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?
Valuing the S&P 500 market index
Valuing the S&P 500 market index

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:

  1. For each company in the index, the expected growth in net income in the first year
  2. 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.

index 1y net income growth tracker finbox
index 5y cagr tracker finbox

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.

Risk Premium
Y1 Growth
Payout Ratio
S&P 500
Alternating assumptions that drive different S&P 500 valuation

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*)

Finbox Implied Equity Risk Premium Follow-Up

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:

Implied equity risk premium calculation on April 4, 2020
Implied equity risk premium calculation on April 4, 2020

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?

Implied equity risk premium tracker using the old methodology
Implied equity risk premium tracker using the old methodology

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?

Damodaran's monthly implied equity risk premium update
Damodaran’s monthly implied equity risk premium update

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.

Damodaran historical implied premium for US equity market between 1960 and 2019
Historical implied premium for US equity market between 1960 and 2019 (source: Damodaran)

Returning to the number crunching, a key difference between the two methods is the choice of inputs.

InputDamodaranFinbox API
Cash flowDividend + buybacksDividend + buybacks – stock issuances
GrowthTop down forecastBottom up forecast
Payout RatioSustainableSustainable
Difference in inputs to compute implied equity risk premium

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%.

Covid-adjusted implied equity risk premium using Finbox API

At the end of the day, it’s up to everyone to determine which method they feel most comfortable with.

DateIERPS&P 500RiskfreeMarket CapEarningsDividendsBuybacksIssuancesCash to EquityNet Cash to EquityY1 Growth FC
Sust. Payout
7/55.32% $2,848.42
5/55.37% $2,842.74
2/55.45% $2,830.71
28/45.35% $2,878.48
25/45.45% $2,836.74
24/45.55% $2,797.80
22/45.76% $2,736.56

27/36.29%$2,630.07 0.85%$23,968,209

S&P 500 Intrinsic Valuation Using Finbox

In the previous blog post we used the Finbox API service to calculate the implied equity risk premium of the S&P 500. Using the Finbox API service we can also do an intrinsic valuation of the S&P 500.


We live in extraordinary and challenging times. The novel Coronavirus (SARS-CoV-2) and related disease (COVID-19) has been spreading around the world for almost three months now. People around the world are urged or forced to stay at home to help governments and communities get the virus under control. The coronavirus will undoubtedly have a lasting impact on our lives.

The virus has already made severe impact on businesses around the world. First, when the Hubei province in China shut down, many global supply chains were also shut down. Now, as more people around the world are no longer able to go to work, many businesses are suffering from a steep decline in demand. For example, the tourism and airline industries have come to a complete halt as people stay at home. A lot of businesses may go under and a lot of people may lose their jobs. And without people earning money to spend, businesses will see a further decline in sales.

Stock markets around the world have also dropped significantly. The Dow Jones dropped more than 35% from 29,551 points on February 12, 2020, to 19,174 points on March 20, 2020. Similarly the S&P 500 Index fell almost 32% from 3386 points on February 19, 2020, to 2305 points on March 20, 2020. The German DAX Index fell over 38% from 13,789 points on February 19, 2020, to 8,442 on March 18, 2020. Fueled by an oil price war, we’re looking at the “fastest bear market” ever.


From February 26, 2020, NYU Stern professor Mr. Aswath Damodaran began covering the impact of the virus on the markets on his blog and YouTube channel:

  • 26/02: A Viral Market Meltdown: Fear or Fundamentals? (blog, youtube)
  • 09/03: A Viral Market Meltdown Part II: Clues in the Debris! (blog, youtube)
  • 16/03: A Viral Market Meltdown III: Pricing or Value? Trading or Investing? (blog, youtube)
  • 23/03: A Viral Market Meltdown IV: Investing for a post-virus Economy (blog, youtube)
  • 31/03: A Viral Market Meltdown V: Back to Basics! (blog, youtube)
  • 08/04: A Viral Market Meltdown VI: The Price of Risk (blog, youtube)
  • 24/04: A Viral Market Update VII: Mayhem with Multiples (blog, youtube)
  • 13/05: A Viral Market Update VIII: A Crisis Test – Value vs Growth, Active vs Passive, Small Cap vs Large! (blog, youtube)
  • 04/06: A Viral Market Update IX: A Do-it-Yourself S&P 500 Valuation (blog, youtube)
  • 19/06: A Viral Market Update X: A Corporate Life Cycle Perspective (blog, youtube)
  • 02/07: A Viral Market Update XI: The Flexibility Premium (blog, youtube)
  • 23/07: A Viral Market Update XII: The Resilience of Private Risk Capital (blog, youtube)
  • 20/08: A Viral Market Update XIII: The Strong (FANGAM) get Stronger! (blog, youtube)
  • 05/11: A Viral Market Update XIV: A Wrap on the COVID market, premature or not! (blog, youtube)
Damodaran S&P 500 intrinsic valuation

In the third blog post, Damodaran provided an updated intrinsic valuation of the S&P 500 index ranging between $2,547.91 (20%) to $2,986.04 (80%).

Using the same Finbox tools we used in our previous blog post, we can also do an intrinsic valuation of the S&P 500.

Data Gathering

To value the S&P 500 index we need the following data inputs:

  • Long-term risk-free rate: 10Y US bond yield (Wikipedia)
  • Company information (Finbox API)
    • Current market capitalization (marketcap)
    • Dividends paid LTM (total_div_paid_cf)
    • Stock buybacks LTM (common_rep)
    • Stock issues LTM (common_issues)
    • Net income LTM (ni)
    • Book value of equity FY (total_equity)
S&P500 company data provided by API service
S&P500 company data provided by API service

To estimate the current value of the S&P 500, we want to use the most up to date information available. That’s why for most metrics we use the last twelve months data points.

Dividend and Buyback Computation

After gathering the raw data, we normalize by weighing the current S&P 500 index against the S&P 500 total market capitalization.

From S&P 500 raw data to index unit adjusted data points

At the moment of writing, March 23, 2020, the index units adjusted data points are:

  • Earnings: $142.92
  • Dividends: $57.44
  • Buybacks: $81.50
  • Issuances: $138.94
  • Cash to Equity: $138.95 (dividends + buybacks)
  • Net Cash to Equity: $129.52 (dividends + buybacks – issuances)

S&P 500 Valuation Inputs

  • Base Earnings: $142.52
  • Base Net Cash Yield: $129.52
  • Expected Y1 earnings growth: PERT distribution (min -25%, mode -5%, max 5%)
  • Expected Y2 to Y5 earnings growth: triangle distribution (min 4%, 7%, 10%)
  • Expected long term riskfree rate: triangle distribution (min -0.51%, mode 0.89%, max 1.5%)
  • Sustainable payout ratio in Y5: 1-g/ROE
  • Equity risk premium: triangle distribution (min 5%, mode 7.18%, max 9%)

S&P 500 Intrinsic Valuation

In the chart below you can find a histogram plot of the S&P 500 intrinsic value. It ranges from $2,001.58 (25%) to $2,425.66 (75%) with a mean of $2,211.15.

S&P 500 intrinsic valuation
S&P 500 intrinsic valuation (March 23, 2020)