S&P500 Fair Value

The discounted cash flow model is a useful tool to frame the question of what the fair value is for the S&P500, and what the market is currently discounting. The implied equity risk premium is the residual value in the DCF at which the price makes sense, and it is derived by solving for the discount rate that equates future cash flows to the current market price of the S&P500. The realized equity risk premium is around \(5\%\) (going back \(100\) years), and if we plug that number into the DCF model (assuming an EPS growth), we get a fair value of 5,084.69

Coming into \(2025\), investors are right to be trepidatious, for many reasons, but mostly because we are coming off two extraordinarily good years for the market, and a correction seems due. That is, however, a poor basis for market timing, because stock market history is full of examples to the contrary. While there is comfort in looking backwards, slicing and dicing data in the hope of getting clues for the future, investing is about the future. Much as we like to believe that history repeats itself, and find patterns even when they do not exist, the nature of markets makes them difficult to forecast, precisely because they are driven not by what actually happens to the economy, inflation and other fundamentals, but by how these results compare to expectations. Going into \(2025\), investors are clearly in a great mood about what is to come this year. To capture the market’s mood, I back out the expected return that investors are pricing in, through the implied equity risk premium.

Implied Equity Risk Premium

The implied equity risk premium is the ultimate market barometer, reflecting the battle between greed and fear that animates market. More generally, its level is determined by macro forces, information disclosure and behavioral forces. The standard approach to estimating equity risk premiums is to look backwards, estimating the extra return investors would have earned, investing in stocks, instead of treasury bonds. These historical premiums are backward looking and noisy. Incorporating inflation in the numbers, and looking are real returns, has significant consequences for returns on all financial assets, but does not have much of an impact on equity risk premiums.

Our preferred alternative is to back out the equity risk premium by looking at what people pay for stocks, using the S&P500, and computing the return that they can expect to make, based upon expected cash flows.The expected return from this approach will be different from the earnings to price ratio because it incorporate expected growth and changes in cash flow patterns. The critique that this approach requires assumptions about the future (growth and cash flows) is disingenuous, since the earnings yield approach makes assumptions about both as well (no growth or no excess returns), and we could argue that the full equity risk premium approach is on more defensible ground than the earning yield approach.

Using this approach at the start of \(2025\) to the S&P500, we back out an implied expect return of 8.91% for the index, and an implied equity risk premium of 4.33% (obtained by netting out the ten-year bond rate on 2025-01-01, of 4.58%). We do think that we face significant volatility (inflation, tariffs, war) in the year to come, and we would be more comfortable with a higher equity risk premium. At the same time, we do not fall into the bubble crowd, since the equity risk premium is not \(2\%\), as it was at the end of \(1999\).

Database

Every argument about markets (from them being in a bubble to basement level bargains) can be restated in terms of the equity risk premium. If we believe that the equity risk premium today (4.33%) is too low, we are, in effect, stating that stocks are overvalued, and if we view it as too high, we are taking the opposite position. If we are not in the market timing business, we take the current premium as a fair premium, and move on. To see how expectations and pricing have changed over the course of the years, take a look at this database, it lists implied equity risk premium at the start of each month going back to \(2018\):

References

[1] Everything Is a DCF Model

[2] COVID-19 Implied Equity Risk Premium

[3] COVID Valuations and Risk Premiums

[4] Global Default Spreads & Risk Premiums

[5] Global Interest Rates Dynamics and Inflation Expectations