Hey Dan - great article, you touched on a few extremely interesting points regarding measuring values relatively rather than absolutely, and I think in current market conditions that's extremely important given the higher RFR.
Although using earnings yield would be a fairly quick metric that investors can gauge for a ballpark understanding, for true valuations I'd argue that earnings isn't an effective measure of current market conditions. Earnings can be quite volatile and sector dependent, and can appear high/low given short term market conditions/moods, it ignores risk and isn't a forward looking measure, and doesn't take into account future growth prospects of the S&P.
In terms of traditional valuation, I've found it much more useful to estimate the IRR of the S&P 500 using the discount rate that would be needed to discount future cash flow projections of the S&P back to the current value. This value uses a variety of assumptions regarding growth, but are taken directly from analyst assumptions and published values (dividends/buybacks and earnings projections to measure cash flows, analyst assumptions regarding growth of cash flows, and terminal rate equal to the risk free rate). By discounting these cash flows back to the present and equating it to the current value of the S&P, we can estimate the IRR (as the discount rate), and subtract the RFR from this value to get the implied equity risk premium.
This value should be updated monthly, to account for changes in projected cash flows and earnings/dividends projections, as well as changing interest rates. This method is forward looking and dynamic, and I'd argue that it's a much better measure of implied equity risk premium. Completely understand that this article was very general in a sense of getting a ballpark estimate of current premiums, but just wanted to share my thoughts. Once again, very interesting article and very well written, and love your work.
Hey Dan - great article, you touched on a few extremely interesting points regarding measuring values relatively rather than absolutely, and I think in current market conditions that's extremely important given the higher RFR.
Although using earnings yield would be a fairly quick metric that investors can gauge for a ballpark understanding, for true valuations I'd argue that earnings isn't an effective measure of current market conditions. Earnings can be quite volatile and sector dependent, and can appear high/low given short term market conditions/moods, it ignores risk and isn't a forward looking measure, and doesn't take into account future growth prospects of the S&P.
In terms of traditional valuation, I've found it much more useful to estimate the IRR of the S&P 500 using the discount rate that would be needed to discount future cash flow projections of the S&P back to the current value. This value uses a variety of assumptions regarding growth, but are taken directly from analyst assumptions and published values (dividends/buybacks and earnings projections to measure cash flows, analyst assumptions regarding growth of cash flows, and terminal rate equal to the risk free rate). By discounting these cash flows back to the present and equating it to the current value of the S&P, we can estimate the IRR (as the discount rate), and subtract the RFR from this value to get the implied equity risk premium.
This value should be updated monthly, to account for changes in projected cash flows and earnings/dividends projections, as well as changing interest rates. This method is forward looking and dynamic, and I'd argue that it's a much better measure of implied equity risk premium. Completely understand that this article was very general in a sense of getting a ballpark estimate of current premiums, but just wanted to share my thoughts. Once again, very interesting article and very well written, and love your work.