Implied Equity Risk Premium Calculation in May 2022

Implied Equity Risk Premium Calculation in May 2022

Yesterday, the ๐’&๐ ๐Ÿ“๐ŸŽ๐ŸŽ ๐ข๐ง๐๐ž๐ฑ ๐๐ž๐œ๐ฅ๐ข๐ง๐ž๐ ๐›๐ฒ ๐Ÿ‘.๐Ÿ% ๐ญ๐จ ๐œ๐ฅ๐จ๐ฌ๐ž ๐š๐ญ ๐Ÿ‘,๐Ÿ—๐Ÿ—๐Ÿ.๐Ÿ๐Ÿ’. Though the crash was due to increased fed rates to curb the rising inflation, i decided to value the S&P 500 index intrinsically to determine the ๐ž๐Ÿ๐Ÿ๐ž๐œ๐ญ ๐จ๐ง ๐ž๐ช๐ฎ๐ข๐ญ๐ฒ ๐ซ๐ข๐ฌ๐ค ๐ฉ๐ซ๐ž๐ฆ๐ข๐ฎ๐ฆ ๐๐ฎ๐ž ๐ญ๐จ ๐ซ๐ข๐ฌ๐ข๐ง๐  ๐ข๐ง๐ญ๐ž๐ซ๐ž๐ฌ๐ญ ๐ซ๐š๐ญ๐ž๐ฌ.

As of yesterday, the ๐”๐’ ๐Ÿ๐ŸŽ-๐ฒ๐ž๐š๐ซ ๐ญ๐ซ๐ž๐š๐ฌ๐ฎ๐ซ๐ฒ ๐›๐จ๐ง๐ ๐ข๐ฌ ๐š๐ญ ๐Ÿ‘.๐ŸŽ๐Ÿ’%, ๐š ๐ฌ๐ญ๐ž๐ž๐ฉ ๐ซ๐ข๐ฌ๐ž ๐Ÿ๐ซ๐จ๐ฆ ๐Ÿ.๐Ÿ“๐Ÿ% ๐š๐ญ ๐ญ๐ก๐ž ๐ฌ๐ญ๐š๐ซ๐ญ ๐จ๐Ÿ ๐Ÿ๐ŸŽ๐Ÿ๐Ÿ, I got the growth rates for S&P 500 index fromย Edward Yardeni‘s research which provides earnings forecasts monthly.

1)Earnings growth forecast for 2023 and 2024 is 9% and 10%

2)US companies traditionally have returned 80% of their earnings in dividends and buybacks.

I get the intrinsic value of the index as 4,176.35. The last trading value of the index as of yesterday is 3,991.24. Thus, i determined the equity risk premium that the market is factoring in for investing in equities using the solver function.


I calculated the ๐ž๐ช๐ฎ๐ข๐ญ๐ฒ ๐ซ๐ข๐ฌ๐ค ๐ฉ๐ซ๐ž๐ฆ๐ข๐ฎ๐ฆ ๐š๐ฌ ๐Ÿ“.๐Ÿ๐Ÿ—%, ๐ฐ๐ก๐ข๐œ๐ก ๐ข๐ฌ ๐Ÿ๐Ÿ“% ๐ฆ๐จ๐ซ๐ž ๐ญ๐ก๐š๐ง ๐Ÿ’.๐Ÿ๐Ÿ’% ๐š๐ญ ๐ญ๐ก๐ž ๐ฌ๐ญ๐š๐ซ๐ญ ๐จ๐Ÿ ๐ญ๐ก๐ž ๐ฒ๐ž๐š๐ซ. This increase in risk premium implies that markets are not optimistic about equities and expect a premium of 5.29% over the ten-year treasury bond rates at 2.94%.

As of May 2022, markets expect an ๐Ÿ–.๐Ÿ‘๐Ÿ‘% ๐ซ๐ž๐ญ๐ฎ๐ซ๐ง (๐Ÿ.๐Ÿ—๐Ÿ’%+๐Ÿ“.๐Ÿ๐Ÿ—%) ๐Ÿ๐ซ๐จ๐ฆ ๐ญ๐ก๐ž ๐’&๐ ๐Ÿ“๐ŸŽ๐ŸŽ ๐ข๐ง๐๐ž๐ฑ (๐›๐ž๐ญ๐š ๐ข๐ฌ ๐Ÿ ๐Ÿ๐จ๐ซ ๐ญ๐ก๐ž ๐ข๐ง๐๐ž๐ฑ), ๐Ÿ’๐Ÿ“% ๐ฆ๐จ๐ซ๐ž ๐ญ๐ก๐š๐ง ๐Ÿ“.๐Ÿ•๐Ÿ“% ๐ข๐ง ๐‰๐š๐ง๐ฎ๐š๐ซ๐ฒ ๐Ÿ๐ŸŽ๐Ÿ๐Ÿ.

Now, we dont know the effect of corporate earnings on the higher interest rate. As of the last quarter, the corporate results were good. However, if the growth rates fail to meet the forecast and the fed continues to hike interest rates, the risk premium will increase.

Thus, in my view, ๐ข๐ง๐Ÿ๐ฅ๐š๐ญ๐ข๐จ๐ง ๐œ๐จ๐ฎ๐ฅ๐ ๐›๐ž ๐ญ๐ซ๐š๐ง๐ฌ๐ข๐ž๐ง๐ญ, and the recent hikes in fed rates would bring the inflation to normalcy, or inflation could be permanent, and the fed would continue to hike interest rates. In the latter case, the ๐”๐’ ๐ž๐œ๐จ๐ง๐จ๐ฆ๐ฒ ๐ฐ๐ข๐ฅ๐ฅ ๐ฌ๐ฅ๐จ๐ฐ ๐๐จ๐ฐ๐ง as companies cannot meet the earnings forecasts.

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